INCOME TAXATION - New York University
INCOME TAXATION Amy Brown
Professor Schenk Spring 1998
I. Introduction
A. Why tax income?
1. Equity = Those with the same ability to pay taxes should pay the same amount in taxes (horizontal equity) and those with a greater ability to pay should pay more (vertical equity).
2. Efficiency = The tax system should interfere as little as possible w/ people’s economic behavior. Taxing income is a good way to go b/c people are not going to stop earning money just because its taxed.
3. Simplicity = Supposedly, Congress figured that taxing income was the easiest way to achieve the goals of equity and efficiency. But the income tax is anything but simple, and produces three types of complexities:
a. Rule complexity = refers to the problems of understanding and interpreting the law.
b. Compliance complexity = complexity involved in keeping the records and filling out the appropriate forms necessary to comply with the law.
c. Transactional complexity = complexity that arises when taxpayers organize their affairs to minimize taxes.
A. The Progressive Income Tax
1. Defined = Different dollars are taxed at different rates, the highest rate being 39.6%.
2. Rationales = Why do we do it this way?
a. Essential to equity = Progressive tax rates are essential to taxation based on ability to pay. Standard assumption is that equal amounts of income are not of equal value to all recipients. The incremental value of additional income is assumed to decline as income rises, justifying a higher tax rate on dollars at the upper end of the spectrum.
b. Reducing inequality = Progressive tax rates are thought to reduce economic inequalities by taking away less from the people with less money.
c. Proportionality of overall tax burden = Progressive income tax rates are needed to offset regressive tax rates in other areas (state and local sales taxes, property taxes).
B. Alternative Tax Bases
1. Head tax = A flat tax on each adult above the poverty level would be the most efficient type of tax—a person could avoid the tax only by dying or becoming poor, so it would have little effect on people’s behavior. But a head tax would be manifestly unfair b/c it ignores people’s different abilities to pay.
2. Benefit theory = Tax people on the extent to which people benefit from government goods and services. But it would be impossible to ascertain the extent and intensity of taxpayer’s demands for use of each public program.
3. Consumption tax = Tax people on the amount of money that they spend. This isn’t a good idea b/c people w/ same amounts of money would pay different taxes—high income people tend to devote a smaller amount of their income to consumption than do lower income people. A person who was born a billionaire and who spent very little would pay less than a blue collar worker who spent all of his income to support his family.
4. Wealth tax = Tax people on the accumulation of capital (savings). But this would encourage people to spend everything they make.
II. What is Income?
• (Gross income) – (§ 62 deductions) = Adjusted gross income (AGI)
• (AGI) – (standard or itemized deductions) = Taxable Income
• (Taxable income) x (% tax) = Taxes owed
• (Taxes owed) – (credits) = Liability
A. Gross Income Defined = § 61 = Gross income means all income for whatever source derived, including but not limited to:
• Compensation for services • Annuities
• Income derived from business • Income for life insurance Ks
• Gains from property • Pensions
• Interest • Discharge of indebtedness
• Rents • Interest from estate
• Dividends • Royalties
• Alimony/ maintenance payments
B. Compensation and Fringe Benefits
1. Compensation (R 1.61-1 and 1.61-2) = Compensation for services is taxable in whatever form it is received: cash, benefits, services, meals, stock, property, etc.
Old Colony Trust Co. v. Commissioner (p. 109) Ts company paid his taxes for him. Court held that payment of tax by the employer was in consideration of the services rendered by the employee and was a gain derived by the employee from his labor, so amount of taxes paid was taxable. Discharge by a third person of an obligation is equivalent to receipt by the person taxed.
a. Tax inclusive base = § 275 = The amount of tax is included in the amount of taxable income to which rates are applied. Tax is levied on the gross amount of compensation even though employee receives a net amount after appropriate amount of tax has been withheld and sent to government.
b. Rationale = If employers could take care of our taxes, our bills, etc. or other obligations w/o tax consequences, we’d just get them to pay us this way instead of in cash and avoid tax liability altogether.
2. Fringe benefits = § 132 = Although fringe benefits qualify as compensation, some are excluded from income:
a. No additional cost service = § 132 (a)(1) = those services provided by an employer to an employee for the employee’s personal use are excluded if:
• The service is offered for sale by the employer to customers in the employer’s line of business
• The employer incurs no substantial additional cost in providing the service to the employee
Example = Flight attendant is allowed to fly for free on a space-available basis.
b. Qualified employee discount = § 132 (a)(2) = Any employee discount w/ respect to property or services provided by the employer to the extent that the discount does not exceed:
• In the case of property, the gross profit % of the price at which property is being offered to customers
• In the case of services, 20 % of the price at which the services are offered to customers
c. Working condition fringe = § 132 (a)(3) = Any property or service provided to an employee to extent that, if the employee paid for the property or service, the amount paid would be deductible under § 162 or depreciable under § 167.
1) Cash payments = R 1.132-5 = Cash payments will not be characterized as a working condition fringe unless the employer requires the employee to use the payment for expenses in connection w/ a specific pre-arranged activity for which a deduction is allowable, verify that payment was used for such purposes, and return any unpaid portion of payment
2) Examples = Computer used at work for employer’s benefit.
d. De minimis fringe = § 132 (a)(4) = Any property or service the value of which is so small as to make accounting for it unreasonable or administratively impracticable.
1) Cash payments = Generally not excludable.
2) Occasional meal or transportation money = R 1.132-6 = Excludable as long as reasonable in amount and provided:
• On an occasional basis
• Necessitated by overtime
3) Examples = Yellow pads, pencils, pens in an office; needles at a nurse’s station.
e. Qualified transportation fringe = § 132 (a)(5) = Includes any of the following provided by an employer:
• Transportation in a commuter highway vehicle if such transportation is in connection with travel b/w the employee’s residence and place of employment.
• Any transit pass.
• Qualified parking
• Subway tokens handed out by employer
f. Nondiscrimination requirements = Exclusion for above fringe benefits is available only if property or service is provided on substantially the same terms to each member of a group of employees defined under a reasonable classification, set up by the employer, which does not discriminate in favor of employees who are officers, owners, or highly compensated employees.
3. Meals or lodging furnished for convenience of employer = § 119 = Meals and lodging are excludable when provided for the convenience of the employer when:
• In the case of meals, they are furnished on the employer’s business premises
• In the case of lodging, the employee is required to accept such lodging as a condition of his employment
a. Overlaps with de minimis fringes and R 1.132-6:
1) Vouchers for outside restaurants = Not excludable under § 119, b/c meals not provided on premises. Possibly excludable under R 1.132-6 as de minimis fringe. Need to know how much voucher was worth, the frequency w/ which vouchers were given, and whether or not employee used it to determine whether it should count as income.
2) Catered dinner at place of business = May be excludable under § 119, b/c on-premises requirement is satisfied. But need to know whether it was for convenience of employer, whether employee was going back to work.
3) Supper money = Not excludable under § 119 b/c cash received not food. May be excludable under R 1.132-6 depending upon amount given, frequency w/ which given, whether necessary b/c of overtime.
Commissioner v. Kowalski (p. 127) T was a New Jersey trooper who received meal allowance payments when he was on patrol duty. § 119 read narrowly would not apply b/c meals were not furnished on business purposes. Court rejected idea that “business premises” for a trooper would be wherever he is one duty, and denied the exclusion. Cash allowances NOT excludable under § 119.
b. Effect on incentives = Tax consequences change the value of the service to the employee and, consequently, change the economics of what the employer has to provide. For example, if the employer knows that he is providing a meal worth x dollars and that the value of such meal will be excluded from the employee’s income, then he can reduce the total amount that he compensates the employee by the amount that he has saved him in tax payments.
c. Equity concerns = Drawing arbitrary lines b/w what type of meals or meal money will be excludable gives rise to inequitable consequences. Consider Ta who earns 40K, 2K of which he spends on food. He is taxed on gross income of 40K. Tb earns 40K, and has 2K worth of meals provided to him by his employer. He is taxed on gross income of 40K also. But Ta only has 38K left to spend while Tb has full 40K. Unfair.
4. Travel expenses
US v. Gotcher (p. 122) T went on expense paid business trip to Germany and brought his
wife along. T did not include cost of trip in income. Court held than trip was clearly for business purpose for T. But for wife, trip was vacation, so value of trip was taxable w/ respect to her.
1) Employer’s motive dispositive = An essential prerequisite for exclusion is a substantial noncompensatory purpose on the party of the employer for providing the good or service in question. An economic benefit from a business trip will be taxable only when the employer’s payment of expenses serves no legitimate corporate purpose.
2) Spouse’s expenses = § 274(m)(3) = Travel expenses are deductible for spouse or dependent only if spouse is an employee of the taxpayer, there is a business purpose for the spouse’s accompanying the taxpayer, and the expenses otherwise would have been deductible.
5. Property transferred in connection w/ performance of services = § 83 = If a person receives property in return for the performance of services, and if the property is nontransferable or subject to a “substantial risk of forfeiture” at the time of transfer, then the property is treated as still owned by the transferor and no income is realized by the transferee.
a. Substantial risk of forfeiture = Where full enjoyment of the property is conditioned upon the future performance of substantial services by the individual.
b. § 83(a) election = When the forfeiture risk is removed or the property becomes transferable, the fair market value of the property at that time, less any amount originally paid for it, is included in the income of the person who performed the services.
c. § 83(b) election = As an alternative to the default rule under § 83(a), the taxpayer may elect to include the property in gross income when received even though it is subject to a substantial risk of forfeiture. A taxpayer would presumably make this election if he expected the property to increase in value.
d. Which do you choose?
Consider T who works for a university and pays 80K for an apartment, which is worth 90K. His ownership is restricted such that he must resell the apartment to the university for 80K if he should resign during next 10 years.
1) Why 83(a) may be preferable:
a) Time value of money = 10K of liability later is worth much less than 10K today. It’s always better to postpone tax liability.
b) Risk of forfeiture = R 1.83-2 = T may not want to pay 10K now, b/c he’d lose the money if he decided to leave the university before the 10 year period was up. Code says that T does NOT get to take loss for what turns out to be an unprofitable § 83(b) election.
c) Other investment = T may want to keep the 10K and earn money on another investment.
2) Why 83(b) may be preferable:
a) Progressive tax bracket = If T thinks that he will be in a higher tax bracket in the future, then it is better for him to pay taxes at a lower rate now.
b) Appreciation = If T thinks that the property will appreciate in value, then he pays 10K now and owes nothing at the end of the 10 year period. He would not owe taxes on the appreciated value until the time of sale. If T decides not to sell, he avoids the additional taxes altogether.
6. Tax Expenditure Fringe Benefits
a. Life Insurance = § 79 = In general, if the employer pays life insurance premiums on the life of an employee and the employee’s estate or family is the beneficiary, then the employer’s premium payments are income to the employee. But the code provides an exclusion for group term life insurance premiums in aggregate of 50K paid by the employer. The cost of the excess over 50K is subject to tax.
b. Contributions by employer to accident and health plans = § 106 = Excludes employer contributions to accident and health plans from the income of employees, whether the employer provides the protection through an insurance company or on a self-financed basis. If the employee purchased accident or health insurance himself, no deduction would be provided (but proceeds in event of sickness or disability would not be taxed under § 104)
1) Compensation for injuries or sickness = § 104 = Excludes compensation for injuries or sickness in the form of workers’ compensation, disability pensions, and annuities received as result of active military service.
2) Amounts received under accident and health plans = § 105 = Excludes benefits paid under employer’s accident and health plan for medical expenses of employees and their families as well as for permanent disfigurement or loss of use of a member/function of the body.
c. Dependent care = § 29 = Payments made by an employer for the care of dependents of its employees are excluded from employee’s income. Exclusion is limited to 5K per year.
C. Imputed Income
1. Defined = The benefits derived from labor on one’s behalf or the benefits from ownership of property are referred to as imputed income. These benefits are not treated as income for tax purposes.
2. Equity and efficiency consequences of exclusion =
a. Equity = Failure to tax imputed income results in similarly situated Ts paying different taxes. If A works overtime and earns $10 which he uses to walk his dog, A will pay taxes on the $10. B leaves work on time and walks his own dog. B pays no taxes on the value of his own services. A and B are taxed differently even though they are left w/ the same amount of money at the end of the day.
b. Efficiency = Failure to tax imputed income produces inefficiencies by causing Ts to make economic choices different from those that they would make in a no-tax world. If it will cost A more in taxes to work the extra time to pay for the dogwalker, than A may walk the dog himself.
3. Rationales for exclusion of imputed income:
a. Conceptual difficulties = If we taxed people on imputed income, where would we stop? Would we have to tax people on shaving themselves when they could have gone to a barber?
b. Practical difficulties = There would be valuation and record-keeping problems. Enforcement would also lead to privacy invasions, if IRS agents had to put cameras in people’s homes to observe all of the services that they provide for themselves.
4. Homemakers = Failure to tax imputed income has HUGE consequences for mothers. It is cheaper for many women to stay home than it would be for them to work and bear the cost of outside childcare. But leads to inequity—people who work for themselves are treated differently than those who work for someone else.
D. Gifts = § 102 = The recipient of a gift does not pay a tax on the value of the gift received.
1. Commissioner v. Duberstein (p. 138) D gave a car to T because T had been helpful in suggesting customers to D. There was no prior arrangement for compensation, and T had not expected to be paid. Court held that this was a gift, not income.
“Detached and disinterested generosity” test = A gift proceeds from a detached and disinterested generosity, out of affection, respect admiration, charity or like impulses. The most critical consideration is the transferor’s intention.
2. Qualified scholarships = § 117 = Gross income does not include any amount received as a scholarship (for tuition, books, fees) by and individual who is a degree candidate at an educational institution.
a. Equity concerns = Compare T who gets a 10K scholarship with the following people who have similar income but are taxed:
• Mom pays Ts 10K tuition
• T works and earns 13K, he takes 10K after taxes and pays tuition.
If we repeal § 117, then we tax people who couldn’t afford tuition to begin with. Alternatively, we could keep § 117 and provide an education deduction for people who have to pay for tuition. But this is inequitable with regard to people who don’t want to spend any of there money on education—especially those who have to spend every penny on food and rent. There’s no real way to treat everyone the same.
b. Efficiency concerns = The exclusion of gifts and scholarships from income has efficiency consequences—makes leisure cheaper, encourages gifts from parents or other donors, results in an overinvestment in education.
E. Capital Appreciation and Recovery of Basis
1. Accounting for costs in determining income = R 1.61-3 = Gross income means the total sales less the costs of goods sold. There are three ways in which T accounts for costs:
a. Immediate deduction = Some costs are “expensed” by deducting them during the year in which they were incurred.
b. Capitalization = A cost is “capitalized” when the purchase price is taken into account upon sale or exchange.
c. Depreciation = A cost is “depreciated” when periodic deductions are allowed for the asset’s cost.
2. Gains derived from dealings in property = § 61(a)(3) = Gains derived from dealings in property are clearly income—the question is when they are income. The code treats them as capitalized expenses.
a. Realization requirement = § 1001 = The amount gained in property is the amount that the owner realizes over his basis in the property. T realizes the gain upon sale or disposition of the property.
b. Determination of basis = § 1012 = The basis of property is its cost. Where T purchases property for cash, her basis is the amount of cash paid. Where T receives property in exchange for services, his basis is the FMV of the property received.
c. Rationale behind realization requirement:
• Administrative burden of annual reporting
• Difficulty and cost of determining asset values annually
• Potential hardship of getting the cash to pay taxes on unrealized gains (people would have to sell the asset in order to pay the tax)
d. Allocation of basis = R. 1.61-6(a) = When a portion of property is sold, the basis must be divided among the parts.
3. Rents received on property = § 61(a)(5) = Rent received on property is taxable immediately as income. It’s realized when you receive it.
Hort v. Commissioner (p. 157) T acquired office building and leased it to a firm. Lessees wanted to get out of the lease, so the negotiated w/ T for a settlement. T did not include settlement in income. He reported a loss—the difference b/w what he would have received from the fulfillment of the lease and the amount of the settlement. T presumably received the present value of the future rental stream as a settlement. It was money that he would have received as rent, so it was income.
4. Windfalls = R. 161-14 = Since § 61 states that gross income is all income “from whatever source derived”, windfalls are taxable.
a. Cesarini v. United States (p. 161) T bought piano for $15 and found over 4K in cash inside. Court held that treasure trove is taxable in the year in which it is found, citing R 1.61-14.
b. Variations on Cesarini:
1) Treasure trove in land = Suppose C finds several thousand tulips in her yard. C would argue either (a) that the value of the land went up, but that there was no realization event, or (b) that there was no increase in value at all, that the price that she paid for the property included that value of the tulips. If the second argument is accepted, then she would not report income even when she sold the tulips—the amount received would be a recovery of basis. If the argument is not accepted, then she includes the value of the tulips in her income upon a realization event.
2) Donating treasure trove to charity = Suppose C finds gold nuggets and donates them to charity. If C intends to take a charitable deduction, then she has to include the value of the nuggets in income.
Haverly v. United States (p. 163) Principal of public school received unsolicited samples of textbooks from publisher. He donated the books to the school library, and took a charitable deduction. Court held that, when a tax deduction is taken for a charitable donation, the value of the donation must be included in gross income. Otherwise, we would be allowing Ts to take deduction for something that was never included in income. Taking deduction was act of dominion over the property. T would not have been able to give and deduct the books if they were not his to give.
3) Cash as treasure trove = Suppose C finds chest of gold coins in her yard, which she uses the next year to purchase various items. This is the equivalent of finding cash, which is taxable when you find it.
5. Realization of losses = Suppose C finds gold nuggets, has them valued at 5K, and reports value as income in year of discovery. Two years later, the value has dropped to 3K. She does not want to dispose of the asset b/c she thinks that the value will risk in the future. Can she claim a loss?
Cottage Savings v. Commissioner (p. 170) T was a savings bank that held a portfolio of residential mortgage loans w/ face value of 6.9 million. Mortgage rates rose and the value of the portfolio dropped. In order to realize a loss, T swapped his interest in the portfolio for an equivalent interest in another portfolio held by another bank. Court allowed T to recognize the loss.
Test of material difference = A loss is realized when property is transferred for other property that is materially different, in kind or extent. In Cottage Savings, court found material difference in the portfolios even though they had the same economic value. So for the nuggets, C would realize a loss when she received the nuggets of different shapes, sizes, etc. even if their economic value was the same.
Allocating the cost of annuities
Determination of basis = The investment in the annuity is the basis, which is recovered as annuity payments are received. It is necessary to determine what portion of each payment is treated as tax-free recovery of basis and what portion is the taxable return on the investment.
Exclusion ratio = § 72 = The Code treats a portion of each annuity payment as a recovery of investment, and the remaining portion as taxable return. A ratable portion of each payment received is excluded from income in an amount expected to restore the capital in full when the final payment is received. Exclusion ration = Investment cost / Expected return.
a. Importance of timing = The Code permits T to underreport income in the early years, and overreport in later years. Alternatively, the Code could treat annuities as bank accounts, taxing T on the amount of “interest” earned on his investment each year. Although the aggregate income reported under either method would be the same, the present value of the tax liability under the § 72 method is less. Compare the two methods:
A purchases an annuity for 7K, which will pay him 1K for 10 years (10K). How much income does he receive each year?
1) § 72 method = Divides the total gain that T will receive over number of years in which he will receive it. He paid 7K for 10K annuity, giving him a total gain of 3K. Dividing the 3K across the 10 year payment period yields interest payments of $300 per year. So for the 1K that T receives each year, $700 will be treated as a recovery of basis (untaxed) and $300 will be treated as income.
2) Bank account method = A 7K investment at 7% interest, with 1K withdrawals over 10 years will also yield a net of 10,000. T would pay a tax on the interest each year. In Y1, T would withdraw 1K, $490 of which would be interest and $510 of which would be principle. $6,490 in principle would be left in Y2. That year, T would receive 1K, $454 of which would be interest and $546 of which would be principle. This would continue for 10 years. The interest is higher in the earlier years because the remaining principle is higher. § 72 saves T money because of the time value of money—he pushes off some of his tax liability to the future, when it’s worth less.
b. Equity and efficiency consequences:
1) Equity = The only people who can take advantage of the favorable treatment of annuities are people who have capital to invest. Wage earners cannot take advantage of this investment. So the wage earner who brings home $490 (from above) will be taxed on the whole amount. So will the person who receives $490 interest from his bank account. The recipient of the annuity receives $490, but is only taxed on $300. § 72 therefore treats people with identical economic incomes differently.
2) Efficiency = Favorable tax treatment of annuities changes people’s incentives—people who can take advantage of annuities will do so, instead of putting money in bank.
c. Deferred annuities = § 72 (b) Suppose T purchases an annuity to pay some amount in the future. During the period between the purchase date and the date when annuity payments begin, interest accrues on the annuity. The interest is not taxed when it accrues, but is taxed as T receives the payments.
1) Example = T purchases 10K annuity to pay him 1K for rest of life. Ts life expectancy is 20 years, meaning that he expects to receive a total of 20K, at 10K profit. He is taxed on $500 each year—10K profit is divided over 20 years.
2) Early cash withdrawals taxed immediately = § 72 (e) = Cash withdrawals before the annuity starting date are treated as income to the extent that the cash value exceeds the owner’s investment. Thus, when cash is withdrawn, interest is taxed first.
d. Mortality gains and losses = § 72 (c)(3) = When an annuity is measured by life, it is uncertain in advance how much will be received. The statute provides that, in such a case, the aggregate amount to be received is to be determined on the basis of life expectancy. The actual payments may be more or less than the amount determined based on how long the person lives. When the annuitant outlives the life expectancy, he has a mortality gain on which he is taxed. When the annuitant dies prior to the expectancy, he has a mortality loss and is able to deduct his unrecovered investment on his last tax return.
6. Life Insurance Policies
a. Where insured dies within term, policies are basically tax-free
1) Interest not taxed = Interest earned on a life insurance policy is not taxed over time.
2) Beneficiary of policy not taxed = § 101 (a) = Beneficiary of life insurance policy is not taxed at all. This leads to BIG bonus if purchaser is hit by bus after paying only one of his premiums, and beneficiary gets thousands of dollars tax free.
b. Tax upon termination of policy = Proceeds received upon the termination of the policy, rather than because of death of the insured, are taxable to the extent that they exceed the total cost of the policy. Proceeds would consist of the return on the investment and the compound interest on those savings.
Borrowed Funds and Discharges of Indebtedness
1. No income when received, no deduction when repaid = A borrower does not realize income upon receipt of a loan, regardless of how the loan proceeds are used. Similarly, he has no deduction when he makes principal payments on the loan. Likewise, the lender does not have a deductible loss upon making the loan and does not realize income at time of repayment—repayment is recovery of capital. These results are appropriate because there is no change in the net worth of either party. The borrower receives an amount of money for which he is liable at some point in the future (so there is no gain), and the lender loses an amount of money which he will recover at some point in the future (so there is no loss).
2. Income from discharge of indebtedness = § 61 (a)(12) = Discharges of indebtedness are taxable as income b/c the discharge frees up assets of the debtor that he otherwise would have had to use to pay the debt.
Zarin v. Commissioner (p. 184) Z borrowed lots of money for gambling. He owed casino over 3 million, but settled with them for 500K. IRS contended that he should report remaining 2 ½ million as income for forgiveness of debt. Z argued that any income from discharge of gambling debt was income against which he could offset his gambling losses under § 165(d), such that he had no net income from gambling.
a. Offsetting losses = § 165 (d) = Permits Ts to offset gambling losses against gambling gains. Tax Court held that Z was attempting to offset his losses against the discharged debt rather than against gambling gains. He received the money before he ever made a bet, so the money could not be characterized as gambling gains against which he could offset his losses.
b. Exceptions to the rule:
1) Bankruptcy = § 108 = Any income from discharge of indebtedness is excludable from the gross income of T if the discharge occurs when T is bankrupt or insolvent. Why? If T doesn’t have the money to pay off his debts, he doesn’t have money to pay taxes on forgiveness of obligations.
2) Purchase price reduction = § 108 (e)(5) = If the seller of specific property reduces the debt of the buyer arising out of the purchase, the reduction is to be treated by both parties as a reduction in purchase price. Example: If A owes B 10K for property that A later discovers to be defective, and B settles with him so that he owes only 7K, 3K reduction is treated as purchase price reduction rather than discharge of indebtedness.
3) Debt not enforceable = In Zarin, the 3d Cir. reversed the trial court which ordered Z to report the debt forgiveness as income. 3d Cir. held that Z had no income from the forgiveness of the debt, since the loan was not legally enforceable to begin with. In other words, court said that since the loan was never enforceable against Z, he had no income when the debt was forgiven. Not really logical—he clearly received a large sum of money tax-free, even if he pissed it away gambling and was not legally required to pay it back. Other courts might reach a different conclusion.
Illegal Income
Collins v. Commissioner (p. 211) C was ticket vendor and computer operator at race track, which had policy prohibiting employee gambling. C violated rules and placed bets on computer w/o paying for them. He ran up 40K in debts. Court held that illegal activities gave rise to gross income.
1. “Consensual recognition” test for what counts as loan = C claimed that his theft resulted in no taxable gain because he had an obligation to repay his employer for the stolen tickets. Court stated that only a loan with its attendant consensual recognition of the obligation is not taxable. There was no consensual recognition of a debt in this case—the employer never gave C the permission to print up betting tickets for himself. He didn’t borrow the funds, he misappropriated them.
2. Misappropriation and restitution = R 1.165-8 = Although embezzlers must report illegal income, they may claim a tax deduction for payments made in restitution. But the deduction is only available for the tax year in which the payments are made
F. Damages
1. Business damages = Raytheon Production v. Commissioner (p. 219)
a. Reimbursements for lost profits = Recoveries which represent a reimbursement for lost profits are income. Since the profits would be income, the proceeds of litigation which are their substitute are taxable.
b. Recovery for injury to good will = Where the suit is not to recover lost profits but is for injury to good will, the recovery represents a return of capital and is not taxable.
c. Deduction for unrecovered losses = § 186 = Code permits Ts to deduct losses that they were not able to deduct fully at the time they were realized (for example, because they had insufficient income at the time injury occurred and net operating loss carryovers expired before they could use them). § 186 allows a deduction in the amount the lesser of the compensation received (minus legal expenses) or the unrecovered losses sustained from the injury.
2. Personal injury damages
a. Physical injury = § 104 (a)(2) = T can deduct amount of damages received for personal physical injuries or physical sickness.
b. Punitive damages = § 104 (a)(2) = Punitive damages are not deductible. Neither are damages for emotional distress, unless T can demonstrate that distress was result of physical injury.
c. Accident and health insurance = § 104 (a)(3) = T can exclude amounts received under health plans whether he paid for premiums himself or whether employer paid premiums (in that case, amounts received would be excludable under § 105(b).
d. Employer contributions = § 105 (a)-(b) = Note that § 105(a) says that amounts received under plans paid for employers are included in T income, but § 105(b) says that this does not apply where amounts are paid to reimburse T for medical care.
G. Tax-Exempt Bonds
1. Interest on state and local bonds = § 103 = Code excludes from income interest on state and local obligations.
2. Private activity bonds = As a response to the increasing issuance on bonds by state and local governments to finance activities other than general government operations or governmentally owned and operated facilities, Congress has limited the issuance of such bonds.
a. Arbitrage bonds = § 103(b)(2) = These are bonds used by a state or local government to acquire other securities with a higher rate of return. In most cases, the interest on these bonds is not tax exempt.
b. Industrial development bond = § 141 (b) = Government acts a conduit, borrowing funds to obtain the tax exemption, but payment of bonds is responsibility of the user of the facility acquired w/ bond proceeds. IDBs are used to attract business to a state or locality. With their increasing popularity, Congress limited their use when:
• More than 10% of the proceeds is for direct or indirect use in a trade or business of anyone other than a governmental unit.
• More than 5% of proceeds are used to make or finance loans to entities other than state or local governments.
3. Equity and efficiency concerns:
a. Windfall to people in higher tax brackets = The purpose of § 103 is to even out the net return of a corporate bond with the return of a municipal bond in order to encourage people to invest in the latter. Municipal bonds pay lower interest; if there were no tax advantage, everyone would purchase corporate bonds which pay higher interest rates. But § 103 evens things out for people in a certain tax bracket. Assume that a municipal bond of 1,000 pays 7.2% interest. Investor M earns $72 in interest, on which he is not taxed. Investor C buys a corporate bond for 1,000 at 10% interest. He earns $100 in taxable interest. If he is in a 28% tax bracket, then we get the right result. Both M and C will be left with $72 after taxes, so we bring C into the municipal bond market when he might have otherwise invested in corporate bonds. But if C were in a 40% tax bracket, then we give him too much of an incentive. He only would have earned $60 after taxes on a corporate bond, so he clearly prefers the municipal bond. The government only needed to pay him 6% interest to draw him into the market. In order to draw in people in the 28% bracket, government provides a windfall to people in higher brackets.
b. Effect of repealing § 103 = If we were designing a tax system now, we could leave § 103 out and just require municipalities to pay higher interest rates in order to compete w/ corporate bonds. But it’s already there, and we can’t repeal it w/o hurting the people who’ve invested at a lower interest rate w/ the expectation that they will come out the same in the end. So the people who would be hurt are the people whose tax advantage had been capitalized into the price paid for the investment.
III. Tax Expenditures
Defined = Tax expenditures are departures from the taxation of economic income which are made for reasons other than administrative feasibility. Said differently, tax expenditures treat certain taxpayers favorably in order to provide particular benefits. The effect is equivalent to a direct subsidy, in the form of foregone revenue. § 103 (above) is a prime example—Congress exempts interest on state and local obligations, forgoing the revenue that it could otherwise obtain. In effect, Congress is subsidizing the activities of state and local governments.
Achieving same result with direct outlays = For any given activity that the government wants to support, it could do it in one of two ways: by providing a direct subsidy, or by providing an exclusion or deduction. Assume that T has $100, and the government wants him to have $10 of cheese. T is in a 30% tax bracket.
1. Direct subsidy = Government gives him $15 in a cheese voucher. This increases his gross income to $115, on which he pays a $35 tax, leaving him with $80. $70 is disposable cash, $10 is money used to buy cheese.
2. Deduction = Government gives him a $32 deduction. He has $100, but his taxable income is only $68. So he pays $20 in taxes, leaving him with $80. $70 is disposable cash, $10 is left to buy cheese.
3. Exclusion = Government allows him $10 of nontaxable cheese. T is taxed on his $100 and is left with $70 and $10 cheese.
Why prefer one method over another?
Visibility = Direct expenditures are more visible than tax expenditures. It was only recently that tax expenditures were even listed and accounted for in the budget. For political reasons, Congress may opt for tax expenditures since they don’t look like spending. If Congress doesn’t want to look like it is supporting an activity, it says “I didn’t give them money, I just didn’t tax them.” Economically, they’re the same. But direct spending looks worse.
Control = Tax expenditures are directed to specific items. The government wouldn’t have the same control over where cash would go. The government could make in-kind distributions instead, but tax expenditures are easier. Take the cheese example. The government would have to build a cheese factory, buy the machines, hire the workers, etc. It’s easier to let people buy the cheese from the already-existing factories and not tax them on it.
Amount spent = With direct expenditures, the government allocates and spends a fixed amount. Tax expenditures are open-ended. How much the government “spends” depends upon how many people take advantage of the exclusion or deduction. So, while the government can control where tax expenditures go, it can’t control how much it will spend.
1. Upside-down subsidies = Tax expenditures are upside-down subsidies in that they provide more benefit to the wealthy than to the lower income Ts. Suppose everyone buying $10 of cheese gets a $10 deduction. Ta has gross income of $200 and is in a 30% tax bracket. She excludes $10 from income, is taxed on $190 and pays $57 in taxes as opposed to $60. The deduction is worth $3 to her. Tb has gross income of $100 and is in a 15% tax bracket. After the deduction, she is taxed on $90 and pays $13 in taxes as opposed to $15. The deduction is only worth $2 to her even though she needs it more. Congress would never make a rule that says: Rich people who buy cheese get $3, but poor people only get $2. But this is the effect of allowing a deduction. Congress could give everyone the same benefit w/ a tax credit, but this would be regressive w/ respect to income—people w/ more money would get the same benefit as people w/ less money.
IV. Deductions
A. Ordinary and necessary business expenses
1. Trade or business expenses = § 162 = T can deduct all ordinary and necessary business expenses including:
• Reasonable allowance for salaries or other compensation for personal services actually rendered
• Traveling expenses while away from home in the pursuit of a trade or business
• Rentals payments required for use of business property
a. Above the line deductions = Ordinary and necessary business expenses are those subtracted from gross income in order to arrive at T’s adjusted gross income.
b. Rationale = Allowing a deduction for the costs of business is essential if we are going to tax net income. If people were never allowed to deduct their costs, they wouldn’t be able to profit.
2. Defining “trade or business”
Commissioner v. Groetzinger (p. 235) Must ask whether T was involved in an activity w/ continuity, regularity, and w/ primary purpose of earning a profit.
3. Defining “ordinary and necessary”?
a. Welch v. Helvering (p. 236) T was secretary of business that went bankrupt. Company’s debts were discharged. T went to work for another company, but decided to pay off debt of bankrupt company as much as he could in order to reestablish his relations w/ his customers. Court held that expenses were necessary, but not ordinary. Payment of another company’s debt was not “ordinary” so it wasn’t deductible.
1) Necessary = Court held that payments were ordinary in that they were “appropriate and helpful”. Apparently, an expense does not have to be essential in order to be necessary.
2) Ordinary = An expense is ordinary when it has the connotation of “normal, usual, or customary”. The expense must be a common or frequent occurrence in the type of business involved. An expense can, however, be ordinary even if it happens only once over a lifetime. The relevant question is whether a business of the type involved would expect to encounter the expense once or twice over the term of its existence.
3) Capital expenditures not deductible = § 263 = Capital outlays are not deductible , but must be capitalized over time. Welch court held that payments of company’s debt was capital outlay for the development of reputation and good will.
b. Gilliam v. Commissioner (p. 239) G was a mentally ill artist who flipped out on a plane and was arrested and prosecuted. He attempted to deduct the legal expenses of defending the prosecution under § 162.
1) Litigation costs usually not deductible = Although one might argue that litigation costs are inherently profit motivated, at least whenever money will change hands as a result of the litigation, courts have held that litigation costs are not deductible as business expenses under § 162. Gilliam court held that it was in no way ordinary for an artist to freak out on a plane and injure people, so it denied the deduction.
2) Origin of claim test for civil actions = Where the claim arises from a personal relationship or difficulty, courts will disallow a deduction for legal expenses. For example, in United States v. Gilmore (p. 241), the court held that a wife could not deduct legal expenses incurred in contesting a divorce settlement, because the action stemmed from her marital relationship and was therefore personal.
3) Origin of government charges for criminal actions = In criminal actions, deductibility turns on the origin of the government’s charges. T may only deduct cost of defending against prosecutions that stem from profit seeking activities.
4. Reasonable allowance for salaries
a. Curtis v. Commissioner (p. 243) C employed Ms. C to join medical practices as VP. She did lots of work, basically ran the offices, working 70 hours per week. C and Ms. C each got about 500K in compensation and she got a lot of other perks—her own condo + Mercedes.
Five-factor test for what counts as reasonable compensation:
1) Role in company = Look at the position held by the employee, hours worked, duties performed, and general importance of employee to success of company. Court held that this factor weighed in favor of Ms. C, since she worked her butt off and was in charge of a lot. Court found amounts of compensation unreasonable and cut them in half.
2) External comparison = Make an external comparison of the employee’s salary w/ those paid by similar companies for similar services. Court found evidence on this factor to be inconclusive.
3) Character and condition of company = Focus is on the company’s size as indicated by its sales, net income, or capital value, and the complexities of the business and general economic conditions. Failure to pay dividends is important factor. Court found that revenues exceeded 2 million annually, and that company was one of the larger and more successful companies of its kind.
4) Conflict of interest = Primary issue is whether some relationship exists b/w the taxpaying entity and its employee which might permit the company to disguise nondeductible corporate distributions of income as salary expenditures. Examples of conflicts of interest would be controlling shareholder or family relationships. Court should evaluate reasonableness of compensation from hypothetical independent shareholder perspective. Here, court found evidence that employees were exploiting their relationship w/ corporation—they were getting huge salaries and leaving the company w/ a negative return of 200% in the relevant years.
5) Internal consistency = Evidence that a company is treating its employees differently would be evidence of unreasonable compensation. Existence of a long-standing, consistently applied compensation plan would be evidence that salary payments are reasonable. Court found this factor unhelpful, b/c the Ts were the only employees of the company.
b. Executive compensation = § 162 (m) = Denies a deduction for compensation in excess of 1 million paid to CEO or four most highly paid employees of a publicly held corporation unless compensation is performance-based (i.e., linked to income generated by employee).
c. Golden parachutes = § 280G = Disallows deduction for payments in excess of reasonable compensation for golden parachute payments. An excess parachute payment is generally defined as a payment whose aggregate present value exceeds three times the average annual compensation includible in the recipient’s gross income over the preceding 5 year period.
d. Expenses contrary to public policy
1) Commissioner v. Tellier (p. 251) T was an underwriter for securities company and was indicted on fraud charges. Court apparently felt sorry for the bastard, b/c it concluded that the payments for unsuccessful defense were deductible as ordinary and necessary expenses of his securities business.
a) No public policy exception = Court found stated that § 162 did not contain a public policy exception, and that an exception was not warranted in this case. Court held that no public policy is offended when a man faced w/ serious criminal charges employs a lawyer to assist him in his defense—it is his constitutional right. Whatever.
b) Taxes not sanctions against wrongdoing = Federal income tax is a tax on net income, not a sanction against wrongdoing. The statute does not concern itself w/ the lawlessness of the income that it taxes.
2) Illegal bribes not deductible = § 162 (c) = T cannot deduct illegal payment to government official. Congress trying to discourage bribes by making transaction more costly.
B. Employee Business Expenses
1. Determining deductibility of employee expenses = Must ask a series of questions to determine whether employee business expenses are deductible:
a. Ordinary and necessary under § 162 = Are the expenses ordinary and necessary to carrying on a trade or business under § 162? If so, they are “above the line” deductions.
1) Above the line deduction = These deductions are subtracted from gross income in order to arrive at adjusted gross income. T can take these deductions even if he takes the standard deduction. § 62 (a)(2)(A).
2) Only reimbursed expenses qualify = In order to qualify as an above the line deduction under § 162, the expenses must be reimbursed by the employer. The employee must provide substantiation to the person providing the reimbursement and cannot be reimbursed for more than the deductible expense.
b. Ordinary and necessary under § 212 = If the expenses are not deductible under § 162, are they ordinary and necessary to the production of income? If so, they are “below the line” deductions, available only to those who itemize rather than take the standard deduction and who meet the 2% floor.
1) Below the line deduction = These deductions are subtracted from adjusted gross income in order to arrive at taxable income.
2) Unreimbursed expenses qualify = All unreimbursed expenses are deductible below the line, and are deductible only if T itemizes deductions, rather than takes the standard deduction.
3) Two percent floor = § 67 = T can deduct miscellaneous itemized deductions only to the extent that, in the aggregate, they exceed 2% of T’s adjusted gross income for the year. Very few T’s will have sufficient expenses to exceed the floor, so the rule promotes simplicity by encouraging T’s to take the standard deduction.
NOTE: Two percent floor does NOT apply to § 132 exclusions.
2. Rationale for the messiness = Congress couldn’t allow people to deduct everything, or the tax base would be reduced to savings. On the other hand, Congress couldn’t get rid of all deductions or it would be taxing gross income w/o accounting for costs. So Congress decided to allow deductions for only those things that assist T in producing income. But problem arises when you try to figure out what expenses are truly for business as opposed to personal purposes, and what business expenses should count as “above the line” as opposed to “below the line”.
3. Equity and efficiency concerns:
a. Equity = The employee business deduction rules clearly treat people w/ the same economic income differently. Assume a 30% tax bracket.
| |§ 132 Fringe |§ 62 deductible expense |§ 212 nondeductible exp |
| | | | |
|What employee has |T gets $99 salary |T gets $99 salary |T gets $100 salary |
| |E gives T the Times ($1) |T buys Times for $1 |T buys Times ($1) |
| |T has $99 + Times |E reimburses T $1 |T has $99 + Times |
| | |T has $99 + Times | |
| | | | |
|What employee is taxed |Gross income $99 |Gross income $100 ($99 + $1 |Gross income $100 |
| |§132 fringe excluded |reimbursement) |No deduction (< 2%) |
| |$99 taxable income |Minus $1 deduction |$100 taxable income |
| | |$99 taxable income | |
b. Efficiency = The inequitable results place big pressure on employers to reimburse employees for business expenses. At no cost, employers can put their employees in a better position by electing either to provide their employees with the Times (so that it is excluded from income under § 132), or to reimburse them for their expense (so that they get a deduction for the reimbursement under § 62).
4. Inherently Personal Expenses
a. Spiritual services
Trebilcock v. Commissioner (p. 265) = T was company owner who paid minister to provide spiritual services to employees. T deducted amounts paid for services under § 162.
1) Personal expenses not deductible = § 262 = Personal, living, and family expenses are treated as taxable consumption and are not deductible.
2) Spiritual services inherently personal = Court held that minister’s services were no different from those services typically provided by spiritual advisers and that all benefits derived from such services are inherently personal under § 262.
b. Clothing
Pevsner v. Commissioner (p. 267) T was manager of boutique who was required to wear boutique clothes. Clothes were expensive. T only wore them to and from work and to business functions. T argued that she would not ordinarily purchases such clothes, that they were too expensive for her everyday lifestyle. She attempted to deduct clothes as an ordinary and business expense under § 162. Court denied deduction.
1) Test for when clothing is deductible under § 162 =
• Clothing is of a type specifically required as a condition of employment.
• Clothing is not adaptable to general use as ordinary clothing.
• Clothing is not worn as ordinary clothing.
2) Objective test for adaptability to ordinary use = Courts will objectively evaluate whether the clothing could be worn outside the workplace. Adaptability for personal or general use will depend upon what is generally accepted for ordinary street wear. No reference should be made to individual taxpayer’s lifestyle or personal taste.
3) Problems with test = The clothing test gets it wrong for people who have to wear ugly navy suits to Cravath and hate every minute of it. It also gets it wrong for the people who dress up as Disney characters to entertain small children, but would be very happy walking around in the Maria Marretta outfits on a daily basis if society did not frown upon such behavior.
c. Domestic services and child care
1) Smith v. Commissioner (p. 270) Married working couples sought to deduct cost of child care as ordinary and necessary expense of employment. Court held that decision to have child and pay for child care was an inherently personal one and would not be deductible. Case was prior to adoption of § 21, below.
2) Qualifying child care credit = § 21 = Ts w/ gross income of 10K or less may offset tax liability by 30% of their employment-related dependent care expenses. That percentage is reduced one percentage point for each addition 2K of gross income that taxpayer earns, until it reaches 20% for Ts w/ incomes of above 28K. There is an absolute ceiling on creditable expenses of $2,400 for one dependent and $4,800 for two or more dependents. Thus the credit cannot exceed $720 for one dependent or $1,440 for two or more.
5. Mixed-motive expenses
a. Graduate education = R. 1.162-5 = Expenditures for education are deductible as ordinary and necessary business expenses only if:
• Education maintains or improves skills required by the individual in his employment or other trade or business, or
• Education meets express requirements of the individual’s employer imposed as a condition of individual’s retention of his established employment status or rate of compensation.
b. Travel away from home
1) Transportation
a) Commuting to and from work = A transportation expense in going between T’s home and T’s regular place of business is a nondeductible personal expense. Rule is defended on grounds that the work location is fixed and the decision to live beyond walking distance is a personal one.
b) Commuting to temporary employment = Transportation expenses incurred in going between T’s residence and a temporary place of business are deductible.
c) Commuting at midnight hour = R 1.61-21(k) = Cost of transportation provided by the employer to employees paid on an hourly basis is valued at $1.50 (regardless of actual value) if the transportation is furnished solely due to unsafe conditions.
2) Food and Lodging
a) Defining “away from home”
United States v. Correll (p. 277) T was a traveling salesman who routinely left home early in morning, ate breakfast and lunch on the road, and returned home in time for dinner. He deducted his costs as traveling expenses incurred while away from home under § 162 (a)(2). Court denied deduction.
Overnight stay required = Court has defined “away from home” to be an overnight stay. The costs of all trips requiring neither sleep nor rest are not deductible. Leads to weird results—people stay overnight when they might otherwise not in order to get deduction.
b) Defining “home”
Hantzis v. Commissioner (p. 279) T was a Harvard law student who was unable to find employment in Boston. She found a job in NY, while her husband kept their apartment in Boston. She deducted cost of transportation, rent, and meals while in NY under § 162. Commissioner denied her deduction on ground that taxpayer’s home for purposes of § 162 was place of business, so she her expenses were not incurred while away from home in the meaning of the statute.
Home is place of business = For purposes of § 162, T’s home is her regular or principal place of business. If T has no principal place of business, then his tax home is his regular place of abode.
c) Temporary employment doctrine = Where T leaves his regular place of business to take a temporary job at another location, T may treat his regular residence as his home and deduct the cost of food and lodging at his temporary job. If duration of new job is indefinite, no deduction is allowed. T is not treated as being temporarily away from home if the period of employment exceeds one year. Expenses relating to employment expected to last for less than a year are deductible, but if the expectation changes, only expenses until that date are deductible.
d) Mixed personal-business trips = Once T establishes a tax home, he must be away from that home in pursuit of a trade or business. If a trip is for mixed business and personal reasons, travel costs are deductible only if the trip is primarily for business purposes. The relative amount of time spent on business as opposed to pleasure is important, but not determinative, as to the primary purpose.
c. Entertainment and Business Meals
1) Business lunches
Moss v. Commissioner (p. 288) T was partner in a law firm, which paid for business lunches on a daily basis. At lunches, litigation problems, assignments, and scheduling were discussed. T wanted to deduct his share of the expenses in calculating his taxable income. He argued that lunches were considered a part of the working day and were a cost incurred in earning income for the firm.
a) Regular business meals not deductible = § 274 (k) = Court disallowed deduction, focusing not on the circumstances bringing the partnership together, but on the fact that the individuals were eating lunch while together. Meals may have contributed to success of the partnership, but other costs contributing to the success of one’s employment are treated as personal expenses.
b) Sutter formula = If a personal living expense is to qualify under § 162, T must demonstrate that it was different from or in excess of that which would have been made for T’s personal purposes
2) Meals with clients
a) Client’s meal and “directly related” test = § 274 (a) = Cost of client’s meal is deductible if it is directly related or associated w/ the active conduct of a trade or business. A business meal is directly related to T’s business if:
• T has more than a general expectation of deriving income or a specific business benefit
• T engaged in business discussions during or directly before or after the meal or entertainment.
• Principal reason for the expense was the active conduct of T’s trade or business.
b) Taxpayer’s meal = Ts meal is deductible when he eats w/ a client. It’s not the same as lunch with coworkers—consumption is being forced upon T. He probably wouldn’t take himself out to lunch at a nice restaurant if he had to pay for it himself. And he can’t take a client to lunch at a nice restaurant and order peanut butter and jelly.
3) Fifty-percent rule = § 274 (n) = Allowing businesses to deduct cost of meals and lodging when Ts clearly get some personal benefit from them is inequitable. People who travel a lot get big benefits, people who don’t get much less. Ts who take clients out a lot benefit, while others don’t. In response, Congress limited the amount of meal and entertainment expenses available to businesses to 50%. This rule affects the businesses, not the employees. Employees can still get full reimbursements for expenses they incur, but the business will only get to deduct 50% of the cost.
a) Business criticism = Businesses were angered at the substitution of Congressional judgment for their own. They argue that they need to spend the money that they do, or they wouldn’t spend it.
b) Hotel and restaurant industry = Hotels and restaurants thought that they would lose tons of business because of the 50% limitation. But there’s no evidence that this has happened—which proves that businesses were right. They must need to spend the money that they spend or they wouldn’t spend it.
Timing of Deductions and Capital Expenditures
1. Three possibilities for when deduction is taken = Ts care about when they get to deduct their costs because of the time value of money. Ts would always prefer to take their deductions up front—they are always worth less in the future.
a. Expense = Deduct cost immediately.
b. Capitalization = Deduct cost later, when you sell the asset.
c. Depreciation = Deduct cost over time.
2. Which Ts will prefer which deduction? Although deductions are always worth less in the futures, not all Ts would want to expense their costs right away.
a. No income to offset deduction = Ts who do not have the income against which to offset the deduction will not benefit from expensing their costs. A present deduction would be worth zero to them, unless they could carry it over.
b. Higher tax bracket in future = People who expect to be making more money in the future will want to put off the deduction to lessen the larger tax liability.
3. Which assets fall in to which category?
a. Assets used up within one year = Where assets are useful to the production of income for only a year or less, they are appropriately expensed. Examples of these assets are labor costs, office supplies, one-year leases, insurance policies.
b. Assets useful for period of years = Where assets are useful to the production of income for a period of years, then we depreciate their cost over time. Real estate and equipment fall into this category. See § 263 and 263A below. We could not expense these assets or we would not be taxing T on the income that they produce each year. On the other hand, we could not capitalize the costs of these assets, or we would be taxing T on his gross income during the years prior to the assets’ being used up and the availability of the deduction.
c. Assets indefinitely useful = When assets are useful for an indefinite period of time, then T is allowed to deduct the cost of his investment only when he sells or disposes of the asset and it is no longer useful to him in the production of his income. Land and stock fall into this category. They don’t necessarily lose value over time, and they don’t disappear at the end of a certain period of time.
4. Consequences of tax deferral—What happens when we put assets in the wrong category?
a. Ways to get the classification wrong:
1) Tax expenditure = If we expense and asset that should be capitalized, we accelerate the deduction and give a big advantage to Ts. Getting it wrong in this way has a huge effect on incentives. See § 179 example below.
2) Tax penalty = If we force T to capitalize an asset that should be expensed, then we shove T’s deduction into the future when it’s worth less and create a tax penalty.
b. Advantages of tax deferral
1) Equivalence to interest-free loan = Assume T in a 50% bracket invests $100 in an asset that be sold in 10 years and that will produce ordinary income at the time of sale. If the cost were deducted immediately, then T saves $50 of taxes in Y1. When the asset is sold in Y10, it produces $100 more income than if cost had been capitalized, so T will repay at the time of sale the $50 of tax saved in Y1. It is as if the government made a 10 year interest free loan of $50 to T.
2) Equivalence to reduction of tax rate = Use same T from above, who arranges to defer $50 of tax for 10 years. Assume T can earn same $50 by placing $27.92 in a bank at 12% interest for 10 years. In other words, he will earn $50 after 10 years of paying taxes on the interest earned from his investment. The 10 year deferral is the equivalent of paying only $27.92 in taxes in Y1. The difference of $22.08 in taxes is forgiven. T’s tax rate has been reduced from 50 to 27.9%.
3) Equivalence to exempting yield from tax = Expensing assets that should not be expensed is the same thing as exempting the income yielded by the asset from tax. Use § 179 to illustrate this.
Election to expense certain depreciable business assets = § 179 = This section allows T to treat a limited dollar amount of capital expenditures as expenses. It is therefore an example of an accelerated deduction which saves T money. Assume T has 20K to invest in an asset that will last forever. The annual before-tax rate of return is 15%. Assume a 50% tax bracket.
a) Rate of return should fall by tax rate = We should capitalize the asset, since it has an indefinite life. So in a 50% tax world, T would owe $1500 in taxes on the 15% return (3K). So his after-tax rate of return falls from 15% to 7.5%, or 50%. The rate of return falls by the tax rate.
b) Expensing the asset exempts the return from tax = If we instead allow T to deduct the cost of the asset in Y1 (even though asset will last forever), then he deducts the 20K cost in Y1 and saves 10K in taxes. His cost therefore drops to 10K—it’s like the government sent him a check for 10K. He collects his 3K return each year, on which he pays $1500 in taxes. So he’s left with an annual return of $1500 on an asset that only cost him 10K for tax purposes. Both the before-tax and after-tax rate of return is 15%. By expensing the asset, T has exempted the return from tax. T eliminated the income tax entirely by expensing an asset that had no immediate cost.
Expensing an asset that has a long life is like cutting the tax rate to almost zero. Expensing an asset with a short life is like cutting the tax rate in half.
5. Acquisition and Disposition of Investment Assets
a. Nondeductible capital expenditures = § 263 = Nondeductible capital expenditures typically include the acquisition and disposition of assets that will last longer than the taxable year. Real estate is the prime example. § 263 provides that no deduction will be allowed for any amount paid out for new buildings or for permanent improvements made to increase the value of property.
1) Litigation costs
Woodward v. Commissioner (p. 308) Ts were controlling shareholders who wanted to purchase the stock of minority shareholders who opposed the extension of the company charter. They claimed deductions for the costs of legal and accounting services rendered in connection with the appraisal of the minority shareholders’ stocks. Court held that litigation costs should be capitalized into cost of the stock and recovered upon sale.
a) Ancillary costs to acquisition of investment asset are capitalized = Legal, brokerage, accounting, and other costs incurred in the acquisition or disposition of property which has a useful life beyond the taxable year are capital expenditures. Ancillary expenses incurred in acquiring or disposing of an asset are as much a part of the cost of that asset as is the price paid for it.
b) Origin of claim test for litigation expenses = To determine whether litigation costs should be capitalized into the cost of the asset, the relevant question is whether the origin of the claim litigated is in the process of acquisition itself. Here, appraisal was clearly part of the acquisition process, so they costs should be capitalized.
2) Costs of constructing property
a) Commissioner v. Idaho Power (p. 312) A public utility used equipment for the construction of its own capital facilities. It depreciated the equipment over the 10-year useful life period applicable for equipment. Commissioner argued that, insofar as the equipment was used in constructing capital facilities, depreciation deductions should be disallowed and the disallowed amounts should be added to T’s adjusted basis in the capital facilities (which would be depreciated over a 30 year period). Court found for the Commission, finding that the exhaustion of construction equipment does not represent the final disposition of T’s investment—T will be receiving income from the building constructed long beyond the life of the equipment, so the investment in the equipment should be assimilated into the cost of the capital asset constructed. Holding was codified in § 263A.
b) Capitalization of direct and indirect costs = § 263A = Code now requires capitalization of virtually all indirect costs, in addition to direct costs, allocable to the construction or production of real property or tangible personal property. These costs include:
• Labor costs
• Equipment costs
• Demolition costs
• Costs of defense of title to property
c) Example = Assume that T is in the construction business. T buys a bulldozer w/ a useful life of 10 years. T uses the bulldozer in the first year to build a warehouse for its other equipment. In the remaining 9 years, the bulldozer is used in performing ordinary construction services to clients. One year of the bulldozer would be capitalized into the cost of the warehouse, and the remainder of the cost would be depreciated over a term of years applicable for the equipment.
b. Nonrecurring expenditures
1) INDOPCO v. Commissioner ( p. 314) T was target of a friendly takeover and incurred significant investment banking and legal fees which it sought to deduct as ordinary and necessary business expenses. Court held that costs incurred for purpose of changing the corporate structure for benefit of future operations should be capitalized into the cost of the newly created corporation.
One-year rule= Capitalization is required if expenditure is expected to produce benefits beyond the year in which the expenditure occurred. But if the economic benefit will be exhausted by the end of the current period, immediate deduction results in the proper measurement of net income.
2) Encyclopedia Britannica v. Commissioner (p. 317) T decided to publish a dictionary that ordinarily would have been published in-house. Because T was short-handed, T hired another company to do all the editing and arranging. Contract contemplated that other company would hand over complete manuscript that would be published and copyrighted by T, in exchange for advance royalties. T attempted to deduct costs under § 162 as ordinary and necessary business expenses. Court referred to one-year rule and to the nonrecurring nature of the expenses in holding that costs should be capitalized.
a) One-year rule = Court concluded that the work was intended to yield T income over a period of years. T would sell the book for how ever many years there were readers, and could not deduct the costs of publishing in the first year of dissemination.
b) Nonrecurring expenditure standard = Court further emphasized that most ordinary expenses are recurring expenses of a noncapital nature, while many capital expenditures are extraordinary in the sense that they are nonrecurring.
3) Advertising costs
a) Rev. Rule 92-80 = Despite the holding in INDOPCO, advertising costs are traditionally deductible under § 162. Only in the unusual circumstance where advertising is directed toward obtaining future benefits significantly beyond those traditionally associated w/ ordinary product advertising or w/ institutional or good will advertising must the costs of that advertising be capitalized.
b) Amortization of good will = § 197 = Intangibles like good will are not deductible under § 162, but are amortized over a 15 year period beginning with the month in which the intangible was acquired.
4) Deductible repairs v. Nondeductible improvements = R 1.162-4
a) Deductible repairs = Expenses associated w/ preserving assets and keeping them in efficient operating condition are deductible under § 162 or § 212. The rationale is that repair does not prolong the original expected life of the asset.
b) Nondeductible improvements = Expenditures for the replacement of property or permanent improvements made to increase the value or prolong the life of property are capital expenditures, similar to the purchase of a new asset.
6. Depreciation and Recovery of Capital Expenditures
In order to calculate the depreciated value of an asset for any given year, you need to know 5 things:
• Depreciable basis
• Salvage value
• Recovery period
• Convention
• Depreciation method
a. Depreciable basis = § 167 (c) = T’s depreciable basis is his adjusted basis in the property, which is the cost of the property.
b. Salvage value = § 168 (b) = The salvage value of an asset is the amount that the taxpayer would expect to recover when he stops using the asset for the production of income. Theoretically, the portion of the taxpayer’s cost allocable to salvage value should not be depreciated. But, for simplicity’s sake, Congress assumes the salvage value of assets to be zero.
c. Recovery period = § 168 (c) = The period over which T will account for the cost of the asset is the recovery period.
Class life = § 168 (e) = In order to figure out the recovery period for an asset, you must first determine its class life under § 168 (e). The class life of property is akin to its useful life, or the period over which the asset is expected to produce income. Once you know the class life under § 168 (e), you go to § 168 (c) to determine the recovery period.
d. Convention = § 168 (d) = Conventions enable T’s to determine when to account for an asset which is bought or sold in the middle of the year.
1) Half-year convention = The Code treats all personalty as purchased or sold on July 1. This means that smart Ts will buy their property on December 31, so that they can take ½ year depreciation for an asset that is one day old.
2) Mid-month convention = For real estate, the applicable convention is the mid-month convention. This means that all rea estate is treated as being bought in the middle of the month in which the purchase was made.
e. Method of depreciation
1) Comparing the different methods in theory
a) Actual decline in value = Given assets with useful lives over a term of years, how would we allow Ts to account for the costs of such assets over time if we could design the perfect tax system? We would allow T to deduct the cost of holding the asset each year. The cost could be expressed in terms of the asset’s decline in value. So for an asset lasting 5 years, T would look at the asset in Y2 to determine how much value was lost in Y1, and deduct that amount for Y1. In Y3, he would determine how much value was lost in Y2, and deduct that amount for Y2. If this is the right way to depreciate the cost of assets, why don’t we do it?
• Administrative nightmare to value assets every year
• IRS would always lose against an army of experts ready to testify how worthless assets were at the end of each year.
b) Economic depreciation = Because of the difficulties inherent in using an asset’s actual decline in value as a measurement for depreciation, the better method of depreciation is economic depreciation, which allows T to deduct an asset’s expected decline in value over a term of years. The expected decline in value for Y1 is the cost of holding the asset in Y1, and this is the amount that T deducts on his annual return.
Example = T purchases an asset on January 1, 1991 for 4K. The asset will produce exactly $1,200 of income each year for five years, and will then become worthless. The investment’s rate of return is 15%. So T has purchased the right to receive $1,200 for 5 years. Each year, T deducts the cost of holding the asset for one year, or the annual loss in present value of the payments.
Present Value of Remaining Payments
| | | | | | | | |
| |PV of asset |1 |2 |3 |4 |5 |Annual PV loss |
|Start Y1 |$4,000 |$1,045 |$905 |$790 |$687 |$573 | |
|End Y1 |$3,427 | |$1045 |$905 |$790 |$687 |$573 |
|End Y2 |$ 2,740 | | |$1,045 |$905 |$790 |$687 |
|End Y3 |$1,950 | | | |$1,045 |$905 |$790 |
|End Y4 |$1,045 | | | | |$1,045 |$905 |
|End Y5 |$0 | | | | | |$1045 |
Total = $4,000
Notice the correct apportionment method is one which starts low and rises. The decline
in value is not the same every year, but it increases over time. The problem with using this method is that:
• It applies only to assets with predictable, flat-income streams (like rents or annuities)
• It assumes no salvage value.
c) Straight-line method = This is the simplest method of allocating the cost of an asset over the recovery period. Under the straight-line method, the cost of an asset is allocated in equal amounts over its useful life. The rate is the reciprocal of the recovery period. So in the above example, for a $4,000 asset lasting 5 years, T would deduct $800 each year, or 1/5 of the cost each year. The result is that T depreciates his asset too fast. He pays less than he should up front, which is beneficial to T because of the time value of money. T can take the difference between the amount he really owes in taxes and the amount he has to pay, and invest it elsewhere.
d) Double-decline balancing method = The code depreciates most assets according to this method, which allocates a larger portion of the cost to the earlier years of the recovery period and a lesser portion to the later years. Under this method, a constant percentage is used, but is applied each year to the amount remaining after the depreciation of previous years has been charged off. The percentage used is twice the straight-line rate. The double-decline balancing method switches to straight-line depreciation when straight-line yields a larger deduction (usually in the last year). In the previous example, a $4,000 asset depreciated over 5 years would need to be depreciated at 20% every year. Double-decline balancing allows T to deduct 40% of the cost in Y1, 40% of the remaining cost in Y2, and so on. Compare the two methods in the charts below. Assume a 40% tax bracket.
Straight-line method
| |Gross income |Depreciation |Taxable income |Tax payable |Net Cash Flow |Present Value at |
| | | | | | |10% |
|Y1 |$1200 |$800 |$400 |$160 |$1040 |$945 |
|Y2 |$1200 |$800 |$400 |$160 |$1040 |$859 |
|Y3 |$1200 |$800 |$400 |$160 |$1040 |$781 |
|Y4 |$1200 |$800 |$400 |$160 |$1040 |$710 |
|Y5 |$1200 |$800 |$400 |$160 |$1040 |$645 |
|Totals |$6000 |$4000 |$2000 |$800 |$5,200 |$3,940 |
Double-decline balancing method
| |Gross income |Depreciation |Taxable income |Tax payable |Net Cash Flow |Present Value at |
| | | | | | |10% |
|Y1 |$1200 |$1600 |($400) |($160) |$1360 |$1236 |
|Y2 |$1200 |$960 |$240 |$96 |$1104 |$912 |
|Y3 |$1200 |$576 |$624 |$250 |$950 |$713 |
|Y4 |$1200 |$346 |$854 |$342 |$858 |$586 |
|Y5 |$1200 |$518 |$682 |$272 |$928 |$575 |
|Totals |$6000 |$4000 |$2000 |$800 |$5200 |$4022 |
Notice that the present value of T’s net income is higher when the double-decline balancing method is used, while the total depreciation and taxes paid are the same under each method. This is front-loaded depreciation designed to give T’s an incentive to invest.
2) Applicable methods in practice
a) Double-decline balancing method = Applies to all personalty with a recovery period of less than 15 years. T should switch to the straight-line method in the 1st taxable year for which using the straight-line method will yield a larger deduction. This will always be the last year of the recovery period.
b) 150% decline balancing method = Applies to 15 and 20 year property, and property used in the farming business. Goodwill would be included in this category (§ 197).
c) Straight-line method = Applies to real estate (both nonresidential real property and residential rental property).
3) Example = T acquires an asset for 20K that will be useful for 10 years. The asset has a class life of 9 years. T is in a 50% tax bracket.
• Depreciable basis is 20K
• Salvage value is 0K
• Recovery period is 5 years under § 168(e)
• Convention period is ½ year
• Applicable method is double decline balancing method; Depreciate asset at 40% per year (20K divided by 5 year recover period).
| |Y1 |Y2 |Y3 |Y4 |Y5 |Y6 |
|Double D |40% x 20K = 8K x ½ |40% x 16K = 6400 |40% x 9600 = 3840 |40% x 5760 = 2304 |40% x 3456 = 1382 | |
| |= 4K | | | | | |
|Straight-line |20% x 20K = 4K x ½|16K / 4.5 yrs = |9600 / 3.5 yrs = |5760 / 2.5 yrs = |3456 / 1.5 yrs = |3456 – 2304 = 1152 |
| |= 2K |3555 |2743 |2304 |2304 | |
The highlighted areas represent the point at which the straight-line method yielded a greater deduction. In Y6, T deducts the amount remaining after 5 years of depreciation. The carryover in Y6 is due to the ½ year convention applied in Y1.
Notice that the straight-line method here is the “caboose method” which differs slightly from the traditional straight-line method used above. The same amount is not deducted across the board; the percentage deducted is recalculated each year according to how many payments are left in the recovery period.
Suppose T sold the asset in Y3 for 12K.
§ 1001 = Gains / loss = (Amount realized) – (adjusted basis)
12K – [20K – 4K (Y1) – 6400 (Y2) – (3840 x ½ convention)] = 4320
4) Effects of current law
a) Alternative minimum tax = Congress created such front-loaded depreciation that it came back and bit them in the butt. In an attempt to undo the self-created damage, it implemented the alternative minimum tax, which makes Ts recalculate everything and comes out closer to economic depreciation.
b) Straight-line for simplicity = Because the Code sets out several depreciation methods, combined with the alternative minimum tax, and because states often have their own methods, many Ts do the straight-line method across the board to avoid all of the complications.
c) Using § 179 as an alternative = Many Ts also elect to expense the maximum amounts allowable under § 179. This depreciates assets much more quickly and basically allows all cost to be deducted up-front for assets below the limits. This section is only available for property used in trade or business.
C. Interest
1. General = Interest received is always taxable. The deductibility of interest paid turns on the purpose of indebtedness—a question that is often unanswerable since Ts generally borrow both to acquire new assets and to keep everything they have.
2. Business interest = § 163 (a) = Interest on indebtedness used to operate a trade or business is a cost to T of doing business and thus is deductible like any other business expense, except in circumstances where interest is required to be capitalized (e.g., when allocable to an asset T is constructing).
3. Investment interest = § 163 (d) = The deduction of debt incurred by individuals to purchase or carry investment property is limited to net investment income. Code wanted to limited the degree to which Ts could milk the tax system by taking current deductions for an investment that yields postponed income.
a. Net investment income = § 163 (d)(4) = Net investment income is total investment income less investment expenses.
b. Carryover provision = T can take an indefinite carryover of interest disallowed due to the limitation. The amount of disallowed investment interest that can be carried over to a succeeding year is not limited by Ts taxable income. Curious result, b/c there is no general carryover of interest expenses; T is able to deduct more as a result of this rule than he would have been able to deduct had the limitations never been imposed.
c. Distinction b/w business and investment interest = This distinction is important in connection w/ the purchase of securities. If Ts activities in connection w/ the securities do not rise to the level of a business, then the interest deduction is limited to the amount of investment income. The management of one’s own securities typically is not a business.
4. Personal Interest = § 163 (h) = Personal non-business interest is not deductible. Personal interest includes any interest which is not:
• Interest paid or incurred in connection w/ a trade or business
• Investment interest
• Interest that would be deductible in connection w/ a passive activity
• Qualified residence interest
5. Tracing interest = R 1.163-8Ta = Since personal interest is not deductible, Ts can only deduct the portion of interest allocable to the portion of the debt that was used for business or investment purposes. But because money is fungible, it is actually impossible to determine which money was used for which purpose. Nonetheless, the Code aims to uncover the purpose of an interest expense by “tracing” loan proceeds to their use.
a. Allocating interest = For any given amount of debt, T takes the % that she spent on business or investment and deducts that % of the total interest paid. For example, A borrows 30K on which she pays 3K interest. If she buys a car for 10K, then the 1/3 interest allocable to the 10K (1K) is nondeductible as personal non-business interest. If she spends the remaining 20K for business purposes, then the 2/3 business (2K) interest is deductible.
b. Commingling of funds = This becomes especially problematic when T borrows funds, adds them to the personal funds already contained in her checking account, and makes a combination of business and personal expenditures. Proportionate allocation will not solve the problem; T needs to know which funds she used for which purposes.
1) Ordering rule = Whenever debt proceeds are mixed with proceeds already existing in the borrower’s account, the Code assumes that T will use the borrowed funds first. So once T deposits a loan, she should always make business and investment expenditures first to ensure that the allocable interest is deductible. If she makes personal expenditures before business expenditures, the Code will assume that she used the borrowed funds for personal purposes and disallow the deduction.
2) Example = Assume T has borrowed 10K for her business, and has 10K in the bank, which she plans to use to buy a car. If she deposits the borrowed 10K and buys the car before she makes her business purposes, then she will not be able to deduct the interest. Timing makes the interest on the 10K allocable to the purchase of the car. T should always make the business expenditures first.
6. Home mortgage interest = § 163 (h)(3) = The main exception to the disallowance of personal interest is the deduction for home mortgage interest. Congress apparently believed that encouraging home ownership was an important policy goal.
a. Two types of qualified residence interest = In order to qualify as qualified residence interest, the debt must be secured by the residence. The maximum amount of interest deductible as qualified residence interest cannot exceed $1 million.
1) Acquisition indebtedness = § 163 (h)(3)(B) = Interest is deductible up to $1 million of debt used to acquire, construct or substantially improve either a principal residence or a second home. The limit is reduced as principal is repaid on the loan, and refinancing does not increase this amount unless used for acquisition or improvement of a home.
2) Home equity indebtedness = § 163 (h)(3)(C) = Interest on debt incurred after the acquisition of the home is deductible up to $100,000, regardless on the purpose or use of the loan, so long as the debt does not exceed FMV of the home.
b. No tracing required = Unlike the rules for business interest, Ts may borrow against their residences to purchase consumer goods and circumvent the elimination of the deduction for consumer interest. If T wants to buy a car, he should borrow against his house instead of borrowing from the dealership, because only the former interest would be deductible.
c. Effects on equity and efficiency
1) Equity = Giving homeowners favorable tax treatment results in unfair treatment of other taxpayers who are unable to take advantage of the tax breaks. The biggest complainers are renters. Consider A and B. A has 100K in the bank, but takes out a 100K loan to buy a house. He pays 10% interest, which he is allowed to deduct. B has 100K in the bank and uses the 10% interest to pay his rent. He gets no deduction. In addition to the inequity as to renters, a person who spends his 100K on CDs and lives in the park is also disadvantaged. His consumption is taxed, while the homeowner’s consumption is not.
2) Efficiency = Ts clearly have an incentive to convert personal indebtedness into qualified residence indebtedness in order to take advantage of the favorable tax treatment. The Code also encourages people to buy homes when they might not otherwise.
7. Tax arbitrage
1) Interest to earn tax-exempt interest = A negative rate of tax can be achieved when a taxpayer can obtain both an interest reduction and the equivalent of a zero rate of tax on the income from the asset purchased with debt. Borrowing purchase tax-exempt municipal bonds presents the classic case. Assume a 40% tax bracket. T buys 100K bond yielding 8% tax free. To finance the investment she borrows 100K at 10%. Before taxes, she would lose 2% on the investment. But because the 8K inflow is tax-exempt while the 10K is deductible, the result is a positive annual return of 2K, i.e. the 4K tax saving (40% of deductible 10K) less the net interest cost of 2K. T makes 2K without spending anything! Where the after-tax rate of interest on the debt is less than the rate of return on the investment, T is making money off the system through arbitrage.
2) § 265 (a)(2) = The Code prevents this kind of scam by denying a deduction for interest on funds borrowed to buy municipal bonds. But the practical difficulty of tracing borrowings to bond purchases may limit the effectiveness of disallowance in some cases.
3) Knetsch v. United States (p. 355) T bought annuity that paid 2 ½ % with borrowed funds payable at 3 ½%. He ended up making a good bit of money, b/c he was able to borrow against the value increase in the annuity to meet his interest payments. See text and Chirlestein p. 140. Court disallowed deduction for investment interest under § 163 b/c transaction was a sham.
D. Personal Deductions
1. Standard deduction = § 63 = The standard deduction is a flat amount which varies with marital status and which may be taken regardless of whether T actually had expenditures. The standard deduction is indexed annually for inflation.
a. Rationales for standard deduction
1) Substitute for itemized deductions = It may be viewed as a substitute for itemized deductions for those Ts whose itemized deductions would be of relatively small amounts.
2) Zero bracket amount = It may be viewed as an adjustment of the tax-rate schedules. The amount of standard deduction in conjunction w/ the personal exemption reflects Congress’s determination of the level of income below which no tax should be imposed.
b. Filing status
1) Married filing jointly = Standard deduction on joint returns is $6,500. Usually beneficial to file a joint return.
2) Married filing separately = Standard deduction is $3,275 for each spouse.
3) Surviving spouse = T whose spouse has died in either of the two years preceding the current year continues to be treated as a married T. In order to qualify as a surviving spouse, however, T must maintain and reside in a household in which a dependent child or grandchild resides for the entire taxable year.
4) Head of household = Standard deduction is $5,750; T must be unmarried for federal tax purposes and must maintain a household in which she lives that is also the principal place of residence for more than one-half of the taxable year of a child or dependent. Ts parent(s) may qualify as dependent(s).
5) Single = Standard deduction is $3,900.
c. Marital status = § 7703 = Code contains special rules for determining marital status and they do not always conform to state law. For example, marital status is determined at the end of the year, so a person who divorces on December 31 is treated as unmarried for the entire year, while a person who marries on December 31 is treated as married for the entire year.
2. Personal exemption = § 151 = Each person is entitled to a personal exemption of $2,500. The amount is indexed annually for inflation, and is phased out for Ts with income above certain levels. Ts are also entitled to an exemption for each dependent; a T who can be claimed as a dependent by another T cannot claim a personal exemption.
3. Earned Income Tax Credit = § 32 = The EITC provides a credit to low income individuals who have earnings. The credit is refundable, which means that even people with no tax liability can receive the credit; they file a tax return simply to receive a cash payment.
4. Credit for elderly and disabled = § 22(a) = Individuals who are permanently and totally disabled may qualify for a credit of 15% of their income up to a specified maximum. Credit was added b/c of concern that those receiving Social Security benefits, which are excluded from gross income, were favored over others receiving comparable forms of retirement/disability income, which is taxable.
5. Itemized deductions = § 67 = Ts who have expenses that exceed the standard deduction may itemize deductions.
a. Limitations
1) Two percent floor = T may itemize deductions only where the aggregate amount of such deductions meets the 2% floor, e.g. exceeds 2% of his AGI.
2) Three percent cap = In the case of an individual whose AGI exceeds the applicable amount (100K in 1998), the amount of the itemized deductions otherwise allowable for the taxable year shall be reduced by the lesser of 3% of the excess AGI over the applicable amount, or 80% of the itemized deductions otherwise allowable for the taxable year.
b. Medical deduction = § 213 = Code allows deductions for medical and dental expenses paid during the taxable year for T, her spouse and her children. Amounts paid for medical insurance and costs of transportation primarily for and essential to medical care are covered by deduction. Medical expenses can be deducted only if they are not compensated by insurance or reimbursed by employers.
1) 7.5% cap = Medical expenses are allowable only to extent that they exceed 7.5% of AGI. This is intended to disallow a deduction for normal medical expenses such as annual physical and dental checkups and supplies for the medicine cabinet. Furthermore, medical expenses are only deductible if together with other itemized deductions they exceed the standard deduction.
2) Narrow definition of medical care
a) § 213 (d)(1) = Medical care includes amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease. Regs indicate that deductible expenses are those incurred primarily for the prevention and alleviation of a physical or mental defect or illness. An expenditure that is merely beneficial to the general health of the individual is not deductible.
b) Jacobs test = In order for an expense to be deductible under § 213 it must be an essential element of treatment and must not have otherwise been incurred for non-medical reasons.
3) Capital expenditures = Capital expenditures are generally not deductible. They qualify as a medical expense only where the primary purpose is medical care of T, his spouse, or his dependent and where the expenditure is not related to the betterment of property. Congress and the IRS have clarified that certain capital expenditures generally do not increase the value of a personal residence and thus generally are deductible in full as medical expenses. These include expenditures made for the purpose of accommodating it to the handicapped condition of T or one of his family members.
4) Cosmetic surgery = Surgery which is directed at improving the patient’s appearance and which does not meaningfully promote the proper function of the body or prevent or treat illness or disease is not deductible. To the extent that reimbursements for cosmetic surgery are given from an employer-funded medical plan, they are not excludable.
5) Equity and efficiency concerns
a) Equity
i) Viewing medical care as consumption = If we view medical care as consumption that should be taxed, just like the OJ and chicken soup that we buy for ourselves when we’re sick, how is § 213 inequitable? Denying the deduction would be inconsistent with § 104 (excluding compensation for injuries or sickness from income) and § 105 / § 106 (excluding amounts received for medical care under employer-funded medical plans from income). So if we conceive of medical care as a personal expenditure from which individuals receive personal benefit, then § 104-06 and § 213 are wrong.
ii) Rejecting idea of medical care as consumption = If we accept the argument that persons receiving medical care have suffered an unusual decline in wealth, and should not be taxed on the restoration of their well-being, does § 213 still get it wrong?
• Those who are made better off than before should be taxed on their betterment.
• All medical care—including OJ and chicken soup should be deductible.
• We should remove the 7.5% floor so that all medical care is deductible.
• We should make medical care a § 62 above-the-line deduction.
• We should provide a deduction for persons who suffer injury but receive no medical care.
iii) Effect of repealing § 213 = Disallowing the medical deduction would decrease equity w/ respect to those Ts benefiting under § 104-06. It would increase equity w/ respect to those who are sick but who receive no medical care, and those who receive medical care but do not meet the 7.5% floor.
b) Efficiency = The current system encourages Ts to bargain w/ employers for insurance—the dollars that Ts receive in the form of medical care will be worth more than the dollars that they receive and use to pay for medical care themselves (assuming that they won’t meet the 7.5% floor). Allowing the deduction also creates an increased demand for medical care, creating a bigger job market. On the other hand, there is a disincentive for Ts to use alternative medical care that may not be fall within the Code definition.
c. Charitable deductions = § 170 = Code allows a deduction for charitable contributions of cash and property.
1) Limitations on deduction
a) No deduction for services = Where a person contributes his or her services to a charity as opposed to money or property, the value of the services donated is not deductible. Allowing such a deduction would be inconsistent w/ non-taxation of imputed income.
b) Fifty percent cap = Individuals are allowed a charitable contribution deduction of no more than 50% of their AGI. Congress wanted to prevent people from eliminating their tax liability entirely by transferring all of the current year’s income to charity. Certain gifts of appreciated property are limited to 30% of Ts AGI.
c) Not subject to 2% floor = Charitable deduction is not subject to the 2% floor on miscellaneous itemized deductions of § 67, but is subject to the cap on itemized deductions under § 68.
2) When is a transfer to a charity a deductible contribution?
Detached and disinterested generosity = Courts have held that deductible charitable contributions must meet the Duberstein test of detached and disinterested generosity.
a) Religious donations
Hernandez v. Commissioner (p. 439) T made payments to Church of Scientology in order to receive services known as “auditing” and “training”. Court denied deductions and held that the payments were part of a quid pro quo exchange. In return for their money, Ts received an identifiable benefit in auditing and training sessions. The inherently reciprocal nature of the exchange foreclosed its characterization as a charitable contribution.
b) Business donations = The Duberstein test is more difficult when the donor is a business who could receive an indirect business benefit such as public recognition of the generosity. Courts have held that, where a quid pro quo transfer occurs, juries may use that as evidence that the dominant purpose of the transfer was the expectation of economic benefit.
c) Gifts to schools and nursing homes = It is often difficult to tell whether donations made by parents to schools that their children attend and donations made by elderly persons to nursing homes in which they may later live are charitable contributions.
Rev. Ruling 83-104 = Whether a transfer of money by a parent to an organization that operates a school is a voluntary transfer that is made w/ no expectation of obtaining commensurate benefit depends upon whether a reasonable person would conclude that enrollment in the school was in no manner contingent upon making the payment, that the payment was not made pursuant to a plan to convert nondeductible tuition into charitable contributions, and that the receipt of the benefit was not otherwise dependent upon making the payment.
d) Gifts earmarked for individuals = Earmarking a contribution for the direct benefit of a particular individual will give rise to a presumption that the contribution is not deductible under § 170.
Davis v. United States (p. 447) Court denied parents of the Mormon church a deduction for payments used to support the missionary activities of their children. Court noted that § 170 permits a deduction only if the contribution is made to or for the use of a charity. The payments in this case were made directly to the children and although the church required them to account for the funds, it had neither possession nor control of the funds.
(3) Gifts of appreciated property = § 170 (e) = T who gives appreciated property to a charity generally does not realize a gain, as she would have if she had sold the property for its fair market value. Nonetheless, the Code generally allows T to deduct the full market value of the appreciated property, so the gain remains untaxed. The benefit is limited by § 170 (e), which reduces the charitable contribution by the amount of unrealized gain in some circumstances. Under § 170 (e), the amount of the charitable deduction for a donation of appreciated property depends on whether the recipient is a private foundation or public charity, whether the appreciation would be taxed as a capital gain or as ordinary income if the property were sold, and whether the gift consists of tangible property or securities.
a) Private foundations = A contribution of property other than marketable securities to a private foundation gives rise to a deduction that is limited to the basis of the property. T can deduct FMV of the property less the amount of capital gain or ordinary income that he would have received upon sale.
b) Public foundations = A deduction for a contribution of property to a public charity is generally the FMV minus the amount of gain that would not have been long-term capital gain.
i) Long-term capital gain = Long-term capital gain is produced when the property has been held for more than a year.
Example = T contributes stock to the Red Cross. The stock has a basis of $100 and FMV of $300. If stock was held for more than a year, it would have produced long-term capital gain if sold, so Ts deduction would be $300. If T had held the property for 6 months, then $300 FMV is reduced by the $200 appreciation which would have been treated as short-term capital gain had the stock been sold. Ts deduction would be $100.
ii) Tangible personal property = If however, the property is tangible personal property that will not be used by the donee in its charitable function, the deduction is FMV reduced by the full amount of appreciation (i.e., the basis of the property).
Example = T contributes a painting to the Red Cross. Painting has a $100 basis and $300 FMV, and T has held painting for more than a year. Red Cross does not intend to hang the painting, so deduction is limited to FMV minus long-term capital gain, or $100. If T gave same painting to art museum, then deduction would be full $300 b/c appreciation would be treated as long-term capital gain and donee intended to use painting in its charitable function.
(4) Gifts of property that has declined in value = When T gives depreciated property to a charity, his deduction is limited to the FMV at the date of contribution. T cannot take a larger deduction equal to his basis in the property. So T should always sell depreciated property in order to recognize a loss, and give the proceeds to charity. Note that the reverse is true for appreciated property—T should never sell appreciated property and donate the proceeds to charity; he would be taxed on his gain, whereas, if he donated the appreciated property, he may be able to take a deduction at the appreciated FMV and avoid the tax altogether.
(5) Equity and efficiency concerns
a) Equity
i) Rationale for the deduction = Some argue that the choice to give property to a charity is a form of consumption and that the deduction is inappropriate. Others contend that a contribution deduction is justified by the fact that the amount given to charity will not be consumed by the taxpayer. Moreover, it is very often inappropriate to tax the ultimate consumer, since many who benefit from charitable gifts are in a zero tax bracket. In this respect, charitable deductions are appropriate: Ts benefiting from the deduction are not consuming anything themselves, and the ultimate consumers should not be taxed on their consumption because they have no ability to pay.
ii) Inequitable results
• Where ultimate consumers have taxable income = If the consumers benefiting from the donation are not below the poverty line, then the above justification falls apart. For example, donations to the opera are deductible, but the beneficiaries are not the poor, so taxation could be justified and non-taxation inequitable.
• Where consumers are below poverty line = If the consumers are in a zero tax bracket, so that the above justification applies, then the Code gets it wrong by allowing charitable deductions only as below the line deductions and by subjecting deductions to the 3% cap.
• Service providers = The charitable deduction is inequitable w/respect to service providers, whose contributions are not deductible. If A works at a law firm for an extra hour, and contributes the $300 earned to charity, she gets a deduction; B provides an hour of legal services for a charity, but does not get to deduct the $300 value.
• Intangible benefits = Arguably, people who feel “good” or “empowered” by their contributions should be taxed, b/c they are getting something in return for their giving. But we don’t put a value on intangible benefits outside of the charitable context, so it is probably equitable to ignore them here.
b) Efficiency = Some believe that the deduction increases charitable giving by significantly more than the amount of lost revenue. Others believe that it may subsidize gifts that would have been made in any event.
V. Acquisition and Disposition of Property
Where property is being acquired or disposed of, there are 3 questions to ask:
• Has T realized a gain or loss?
• If so, is the gain or loss recognizable?
• If so, is the gain or loss a capital gain/loss or a gain/loss of ordinary income?
Realization of gains and losses
1. Amount realized = § 1001 = The amount realized from the sale or disposition of property is the sum of any money received + FMV of any property received + amount of debt assumed.
2. Basis of purchased property = § 1012 = In order to determine whether a gain or loss has been realized, T must know his basis (cost) in the property so that he can subtract it from the amount realized. Where T pays cash for property, her basis is amount of cash paid.
a. Adjusted basis = § 1016 = T should adjust his basis for expenditures chargeable to the improvement of the property and for depreciation deductions.
b. Bargain purchases = Basis is generally cost even if T has underpaid or overpaid for the property. If the property is purchased at less than FMV, then T takes a cost basis and is not taxed on gain until she disposed of the property at FMV. Similarly, if T overpays for property, the basis is the amount paid and the loss will be realized only when she sells the property for its fair market value
c. Property exchanged for property = Generally, and arm’s length transaction will involve an exchange of properties of equal value and any difference in the values will be accounted for by the transfer of cash. The exchange will usually be a realization event and any gain or loss on either side of the transaction will be recognized. As to the basis of the property purchased, courts have construed it to mean the value of the property received.
d. Property exchanged for services = § 83 = Where T receives property in exchange for services, basis is FMV of property received at the first time that the rights of the T are transferable and not subject to a substantial risk of forfeiture. See supra IB-5 (compensation).
3. Basis of property acquired by gift = § 1015 = For gifts, the recipient’s basis in the property for purposes of determining gain is equal to the donor’s basis in the property. The basis is “transferred” or “carried over”. This reflects a congressional determination not to tax accrued income at the time of gift, but to preserve the basis so that the tax is triggered upon subsequent disposition.
a. Basis for determining loss = In determining loss, the basis is either the donor’s basis or the FMV at the time of gift, whichever is lower. In combination, the basis rules for gifts permit the transfer of tax on accrued gains to the donee, but not the transfer of the tax benefit of losses.
b. Part gift and part sale = R 1.1015-4 = If the transaction is part gift and part sale (e.g., mom sells son $100 property for $75), then the initial basis of the transferee is the greater of the amount paid by the transferee for the property or the transferor’s basis. For determining loss, however, the basis is never greater than FMV of property at the time of transfer.
4. Basis of property acquired from a decedent = § 1014 = The basis of property acquired from a decedent is FMV of property at the date of the decedent’s death. This section reflects the policy decision that death is an inappropriate time to tax accrued gain on property passing to others from the decedent. The result of this decision is a “stepped up” (or stepped down) basis for the transferee whereby the accrued gain (or loss) on the property will never be subject to income tax (or available to reduce tax).
5. Basis of property acquired in divorce settlement = § 1041 = No gain or loss is to be recognized on any transfer of property between spouses or on a transfer incident to divorce b/w former spouses. The recipient takes a carryover basis in the property equal to the adjusted basis of the transferor, as with gift transfers. But unlike the gift rule of § 1015, one spouse can transfer a loss to another spouse. The ultimate result is a tax deferral: upon eventual disposition, the spouse will pay taxes on gains or losses accrued both throughout the marriage and throughout the time that he or she held the property independently.
6. Basis of property acquired with debt = § 163 (h)(3)(B) = The general rule is that the debt incurred to purchase property is included in its basis.
a. Two types of liability
1) Recourse debt = Where the borrower is personally liable for repayment of the debt. Upon default, the lender can look not only to any asset securing the debt, but also to the borrower’s other assets for repayment.
2) Nonrecourse debt = Where the borrower is not personally liable for repayment. The lender can obtain satisfaction of the obligation only from the property securing the debt.
b. Recourse and nonrecourse debt treated alike for calculation of basis = In Crane v. Commissioner, the Court established that both recourse and nonrecourse debt will be included in the basis of the asset it finances. When the property is sold, any balance of the recourse or nonrecourse debt is included in the amount realized. The rationale behind this rule is one of tax symmetry: since the law treats nonrecourse debt as a cost when property is acquired, then, to be consistent, relief from such debt has to be treated as a real benefit when the property is sold. The taxpayer still benefits:
1) Enables T to recover costs not yet assumed = If the property is eligible for depreciation deductions, including the borrowed amount in basis enables T to recover costs that she has not yet paid or assumed directly.
2) Enables T to recover acquisition costs not paid = If the money is borrowed through a nonrecourse mortgage for which T has no personal liability, it may be possible for her to recover through depreciation putative acquisition costs for which she may never have to put up any of her own money.
3) Enables T to take interest-free loan = Although the amount of outstanding debt will be included in Ts amount realized upon eventual sale (offsetting earlier depreciation deductions), T enjoys the time value of the depreciation deductions.
4) Example: A acquires Blackacre for 60K in cash and assumed a 330K mortgage. He took deductions of 50K. A then sells the property to B for 75K cash and assumption of 330K mortgage. What is A’s gain or loss and what is B’s basis in the property?
• A’s AB = 60K (cash paid) + 330K (debt assumed) – 50K (depreciation) = 340K
• A’s AR = 75K (cash received) + 330K (debt relieved) = 405K
• A’s gain = 405K (amount realized) – 340K (adjusted basis) = 65K
• B’s basis = 75K (cash paid) + 330K (debt assumed) = 405K
We can infer that the property increased from 390K, at time of A’s purchase, to 405K, at time of B’s purchase. We tax A not only on the 15K increase in value, but on the 50K depreciation deductions which he took on property that did not decline in value. But the result is not a wash—A got to use 50K for free during the time that he held the property.
c. Where value of securing property is less than debt owed = When the securing property is less than the mortgage debt, then the bank will generally foreclose, sell the property for its FMV, and keep the proceeds owed to it by the borrower. The relevant question is what amount the borrower will be deemed to have realized upon relief of the mortgage—a reduced amount that reflects the FMV, or the full amount of the debt assumed? Take the example from above as an illustration.
1) Recourse debt = In the above example, A took out 330K mortgage and property declined in value from 390K to 300K. The bank forecloses, sells the property for 300K, and keeps the proceeds. A’s adjusted basis has not changed—his cost remains 340K. The bank relieves A of 300K—A realizes the amount of debt relieved up to the FMV of the property. So he has a total loss of 40K (AB of 340K less income of 3000). But A still owes the bank 30K, and the bank can come after his other assets to get it. Generally, the bank will simply relieve A of the additional 30K owed to it. A thus realizes 300K (relief from sale) + 30K (cancellation of indebtedness income), leaving him with a loss of 10K.
2) Nonrecourse debt = Where the value of the securing property drops below the value of the debt and the borrower is not personally liable, he has no incentive to pay. When the bank forecloses for FMV, he will get nothing back, no matter how much he has paid on the obligation. Every penny paid would be thrown away. The borrower would rather abandon the property to the mortgagor, and recognize a greater loss loss.
a) Commissioner v. Tufts (p. 195) Ts borrowed $1.85 million to construct an apartment building. They made no cash investment and their debt was in the form of a nonrecourse loan. Over the next 2 years, Ts took depreciation deductions of $450K which reduced their basis to $1.4 million. Investment was not profitable, so Ts sold to another investor, who paid nothing in cash but assumed the mortgage. FMV on date of sale was not more than $1.4 million. Since the value of the property represented the limit of their liability, Ts argued that no more than $1.4 million could be included in the amount realized. Court disagreed. Because Ts included the full $1.85 in their basis and took depreciation deductions based on that amount, they had to realize the full amount upon sale. Accordingly, Ts realized a gain of 450K upon sale.
b) Crane rule of tax symmetry applies = When Ts include a loan in their basis for the asset which it finances on the understanding that they have an obligation to repay the full amount, then, when the obligation is relieved, they necessarily realize the full amount of that relief. FMV of the property becomes irrelevant. So in the example above, if the loan were nonrecourse, A would realize 330K, even though the bank sold the property for only 300K and could have held A liable only up to that amount. Again, A would have a loss of 10K. Allowing A to take a loss of 40K would allow him to recognize a loss that he never felt.
c) Determining the purchaser’s cost = In a Tufts-like case, where the original mortgage loan must be treated as an amount realized by the property sellers (e.g., $1.85 million), must we treat the property buyer as having an equivalent cost? If so, property having little value but subject to large nonrecourse indebtedness would become attractive to investors solely as a source of depreciation and accrued interest deductions. The investor would never intend to pay off the mortgage debt. His sole aim would be to obtain the tax benefits deriving the tax benefits deriving from the ownership of a depreciable asset whose cost for tax purposes would include the full amount of the unassumed mortgage.
i) Estate of Franklin v. Commissioner (p. 205) = Where property is known to be worth less than the nonrecourse debt at the time it is acquired, then the purchaser’s basis should be limited to the lower value figure. While Crane did hold that non-recourse debt is to be treated as a real cost to the purchaser of encumbered property despite the absence of personal liability, the rule assumes that the debt is real debt—that an investor would incur the obligation for economic reasons with an intention to fulfill it. No one would be willing to pay more for property, or to borrow more to buy it, than the property was actually worth. So, when the nonrecourse mortgage exceeds the value of the property when acquired, such excess should not be regarded as real indebtedness and should not be included in the buyer’s cost.
ii) Serving goal of tax symmetry = Tufts should be understood as holding only that T must treat a nonrecourse mortgage consistently when he accounts for basis and amount realized. So in a Franklin situation, where the amount of the mortgage exceeds the FMV of property securing it when debt was first incurred, mortgage is not included in the basis and will not be included in the amount realized upon disposition (foreclosure). In a Tufts situation, where the value of the security exceeds the debt initially, the debt will be included in the basis and likewise will be included in the amount realized upon foreclosure, even if the amount of debt then exceeds the FMV of the property.
d) After-acquisition mortgage = Ts often take out second mortgages on their homes when the home appreciates in value. After-acquisition mortgages are NOT factored into Ts basis in the property.
Recognition of Losses
1. Business losses = § 165 (a) = In general, only losses from property used in a trade, business, or income producing activity are deductible.
a. When losses occur = A loss produces tax consequences only when it is realized. The time of realization is when property is sold, exchanged, or otherwise disposed of. Thus, a mere decline in value is insufficient to create a loss for tax purposes.
b. Amount of loss deduction = § 165 (b) = The amount of the loss deduction is the adjusted basis in the property.
c. Distinguishing business from nonbusiness profit seeking losses
1) Treatment over time = Business losses generally receive more favorable treatment over time— in the form of § 172 net operating loss carryforwards or carrybacks—than do investment or transaction-for-profit losses.
2) Above versus below the line deductibility = Trade or business losses are deductible from gross income rather than AGI and therefore can be taken advantage of even if the taxpayer does not itemize deductions. Transaction-for-profit losses, however, are deductible above the line only where they result from a sale or exchange of property. Otherwise, they must be itemized and are allowed only to the extent that, together with other deductions, they exceed the standard deduction.
3) Ordinary versus capital losses = Many nonbusiness losses are capital losses whose deductibility is limited, while business losses are more likely to be ordinary losses deductible in full against ordinary income.
d. Distinguishing profit seeking from personal losses = § 165 denies a deduction for personal losses (other than theft or casualty losses, see infra). This rule corresponds to rule of § 262 disallowing deductions for personal expenses. § 165 requires that the transactions that produced the losses for which the taxpayer seeks a deduction have been entered into for profit.
1) Residential property = The problem of distinguishing nondeductible personal losses from deductible income seeking losses arises most frequently w/ regard to residential property that has been used or offered for both purposes. The result will often depend on whether the property was primarily used for a residence and secondarily to generate profit, or vice versa.
R 1.165-9 = If the property was used first as a residence, then rented for a period and sold, a deduction will be allowed if the property has been appropriated to income-producing purposes.
2) Gambling losses
a) Deductible to extent of gambling gains = § 165 (d) = A gambling loss is presumed to have an element of personal consumption. To prevent taxpayers from using such consumption-related losses to reduce the tax otherwise payable on other unrelated income and to permit the deduction of losses only when incurred in business or profit seeking activities, § 165 (d) allows gambling losses to be deducted only to the extent of gambling gains.
b) Deductible as ordinary and necessary business expense = § 162 = In Commissioner v. Groetzinger, the court held that a professional gambler engages in a trade or business and may deduct the costs of his gambling as ordinary and necessary business expenses if he is involved in the activity with continuity and regularity and w/ the primary purpose of earning income or a profit. Allowing a § 162 deduction permits any excess gambling losses over gambling winnings to be carried back and forward to other taxable years under § 172.
3) Partial deductions for mixed motive losses = When part of a property is used for one purpose and part for another, or when the same property is used at different times for different purposes, losses from the sale of the property can be allocated b/w the different uses. The deduction is allowed in proportion to the business or income producing use in the same way that a taxpayer’s basis in the property is allocated b/w personal and business uses for depreciation.
2. Hobby losses
a. Safe harbor = § 183 = The hobby loss section provides guidelines for determining whether an activity is entered into for profit. There is a rebuttable assumption that an activity was not engaged as a hobby if the activity produced profits for 3 out of 5 consecutive years ending w/ the year in question.
b. Facts and circumstances test = R 1.183-2(b) = If an activity cannot meet the presumption, T may still attempt to prove that it is an activity engaged in for profit with a showing of certain factors:
• The manner in which T carried on the activity
• The expertise of T or his advisors
• The time an effort expended by T in carrying on the activity
• The expectation that the assets used in the activity may appreciate in value
• T’s history of income or loss w/ respect to the activity
• Amount of occasional profits which are earned
• Financial status of T
• Whether elements of personal pleasure or recreation are involved
3. Casualty losses = § 165 (c)(3) = As an exception to the rule that personal losses are not deductible, the Code allows a deduction for personal losses arising from fire, storm, shipwreck, theft or other casualty.
a. Suddenness and foreseeability = There has been much debate on what incidents qualify as “other casualty”. Courts often evaluate the degree to which the event causing the loss is similar to a fire, shipwreck, or storm in their suddenness and unforeseeable nature.
Kielts v. Commissioner (p. 381) T was the owner of a diamond ring. The diamond came out of its mounting due to a fairly strong blow to one side of the ring. T could not recall when such a blow might have occurred. Court allowed the deduction, characterizing the loss as an accidental one due to sudden and unexpected force.
b. Amount of loss = R 1.165-7(b) = The amount of deduction on personal property is limited to the lesser of FMV before the casualty less FMV after the casualty, or the property’s adjusted basis. This is not the case for casualty losses on business assets—in those cases, T can deduct his adjusted basis in the property, to the extent that it exceeds the FMV of the asset after the casualty.
1) Determining FMV = What it costs to repair the property is some guideline to the FMV after the accident. What it costs to replace the asset is irrelevant.
2) Example = Suppose Ts car is destroyed. T paid 20K for car, but it was only worth 8K at time of accident. After the accident, it was worth 1K. T’s deductible loss is limited to 7K (the difference in FMVs). The remaining 11K of basis is not a loss at all, but is attributable to T’s consumption, which is not deductible. If T had used the car for business purposes only, then he would get to deduct the entire amount of his adjusted basis in the property (20K), less any value remaining in the property after the accident (1K), for a total deduction of 19K.
c. Limitations on deduction = § 165 (h)
1) Only extreme losses deductible = Where personal casualty losses for any taxable year exceed the personal casualty gains for that year, losses are limited to the amount that exceeds 10% of AGI and are deductible only as itemized deductions. Only uninsured casualty losses exceeding $100 are taken into account. No deduction is permitted if T does not file a timely insurance claim to the extent that the policy would provide reimbursement.
2) No deduction permitted for gross negligence = T is entitled to take a deduction even if the casualty results from her negligence, but not if it is intentional or results from gross negligence. It’s not clear just how “gross” the negligence has to be—courts have allowed deductions for theft where T all but watched the thief walk away w/ his property, and for car accidents where T caused the accident.
4. Loss limitations preventing abuse of realization requirement
a. General problem = People will never create a loss in order to get a deduction—for every dollar lost, they would only get back their tax bracket % back by taking a deduction. But people will want to accelerate losses because of the time value of money. They may not want to sell a depreciated asset on which they could take a loss, because they may think that the asset will go up in value at a later date. So they find ways to keep the asset, and realize the loss at the same time. This pisses courts off, and they won’t let people get away with it.
Fender v. United States (p. 387) F was an experienced investment banker who established 2 trusts for his sons. The trusts had large capital gains during one year, and F sought to offset the gains by selling bonds that had declined in value. He sold the bonds to a Bank over which he had 40.7% control, and realized a large loss which he used to offset the gains on the trusts. 42 days after the sale, the bonds had appreciated in value and he bought the bonds back from the Bank. Court held that b/c T controlled the Bank and could ensure that the loss from the sale of the bonds could be recaptured through repurchase, he suffered no real economic loss necessary for a § 165 deduction.
b. Transactions between related taxpayers = § 267 = Code disallows deductions for losses from sales or exchanges of property, whether direct or indirect, b/w certain related people, such as family members, or corporations and their majority (50%+) shareholders. The assumption is that the related parties are one economic unit, such that any sale is illusory and allows the unit to hold onto an asset and recognize a loss at the same time.
1) Amount of gain where loss previously disallowed = § 267 (d) = Where the related buyer later sells the property for a gain, § 267 gets the right result. Assume that A buys a house for 200K and sells it to her son for 150K. The son turns around and sells the property for 300K. § 267 tells us that we reduce the amount of the son’s gain from the sale (150K) by the amount of the mother’s disallowed loss (50K). His gain is then 100K, which represents the true amount of appreciation over the initial cost of the asset (300K sale price, less 200K basis). Otherwise, the son would have to over-report his gain.
2) Amount of loss where loss previously disallowed = § 267 (d) = If the son sells the property for 50K, he reports a 100K loss, even though the economic unit lost 150K (200K basis, less 50K sale price). So where the related buyer sells the property for a loss, the provision’s results are draconian—the previously disallowed loss is never recognized. Lesson: Don’t ever sell depreciated property to relatives!
c. Wash sales = § 1091 = Code disallows a loss from a sale preceded or followed by a purchase of substantially identical securities w/in a 30 day period. The basis of the stock purchased is that of the stock sold, plus any additional amount paid on the repurchase, so that losses are deferred, not lost.
5. Bad debts = § 166
a. Business bad debts = A business bad debt is deductible in full as an ordinary loss. This makes sense given that lenders do not report anything when they make loans to borrowers; there is an assumption that the loan will be repaid and that neither party’s balancing sheet has changed. When repayment does not occur, the lender takes a loss under § 166 and the borrower has discharge of indebtedness income under § 108. Partially worthless business debts (i.e., debts of which only a portion will remain unpaid) can be deducted to the extent charged off by the taxpayer on his books.
b. Nonbusiness bad debts = An individual may deduct a nonbusiness debt only when it is wholly worthless (i.e., none of debt will be repaid, usually b/c borrower is insolvent), and only as a short-term capital loss, which is not as valuable as an ordinary loss.
c. Question of dominant business motivation = To determine whether the debt qualifies as a business bad debt or a nonbusiness debt, courts ask whether the debt resulted from a loan made for a dominant business purpose. The determination turns on the particular facts at hand when both investment and business reasons are present.
United States v. Generes (p. 422) T owned 44% stock of corporation for which he originally invested 39K. He was also president of the corporation, for which he received an annual salary of 12K. To help the company through financial difficulties, T loaned the company 300K. Company went bankrupt and T was never repaid. He claimed a bad business debt deduction, asserting that he made the loans in order to protect his job and his salary—a legitimate business interest—rather than his investment. Court disallowed deduction, since his 12K before tax salary was clearly not enough of a business motivation for a loan of 300K. T made the loans to protect his minority investment in the company, so they could not be deducted under § 166.
A. Recognition of Gains
There are 3 exceptions to the general rule that a gain is recognized upon realization:
1. Exchanges of Like-Kind Properties = § 1031 = No gain or loss is recognized when certain property held for productive use in a trade or business or for investment is exchanged for property of like kind. This section is mandatory—T’s cannot opt out of nonrecognition.
a. Defining like-kind = The term “like-kind” refers to the nature of the property exchanged rather than to its grade or quality. The transfer of real for personal property, for example, would not qualify, whereas the transfer of improved realty for unimproved realty would qualify.
b. Ineligible property = The gain or loss on many common investments cannot be deferred. Ineligible property includes stock, certificates of trust or beneficial interests, other securities or evidence of indebtedness, and partnership interests. Inventory or other property held primarily for sale is also excluded.
c. Determining basis = § 1031 (d) = When like-kind properties of equal value are exchanged in a non-recognition transaction, the basis of the property given up becomes the basis of the property received.
1) Treatment of boot = When like-kind properties exchanged are unequal in value, one party may transfer cash or stock to the other in order to equalize the transaction. In such cases, T will recognize a gain, but not loss, on the transaction to the extent of any boot received. His transferred basis in the new property is decreased by any money received and increased by any gain recognized.
2) Formula = T’s basis in the new property is his old basis in the property he is giving up + recognized gain – recognized loss – cash received.
• Include old basis so that gain is deferred and realized upon sale of new property.
• Include recognized gain in new basis so that it is not taxed again upon sale of new property.
• Subtract recognized loss so that T does not get double-deduction upon sale of new property.
• Subtract cash or debt received b/c they have only one basis and cannot be transferred—Cash and debt can only have a basis equal to their face value.
3) Example = Suppose T exchanged a Ford used in his business (AB = $100, FMV = $150) for X’s Chevy (AB = $50, FMV = $400). T also transferred stock (AB = $500, FMV = $250) to complete payment for the truck.
a) Result to T = T realizes a $50 gain on the disposition of the Ford and a $250 loss on disposition of the stock. The gain is not recognized under § 1031, but the loss on the stock is recognized b/c a stock-car exchange is not like-kind. T’s basis in the Chevy is his old basis in the Ford and stock ($600) + recognized gain ($0) – recognized loss ($250) – cash received ($0) = $350. If he sold the Chevy immediately for its FMV ($400), he would recognize $50 gain, which reflects his unrecognized gain on the Ford.
b) Result to X = X realizes a gain of $350 on his disposition of the Chevy which is not recognized under § 1031. X does recognize, however, a gain up to the value of boot received in the amount of $250. X’s basis in the Ford is his old basis in the Chevy ($50) + recognized gain ($250) – recognized loss ($0) – cash received ($0) = $300. If he sold the Ford and stock immediately for their FMV, he would recognize a $100 gain, which reflects his the amount of unrecognized gain on the Chevy.
d. Swapped real estate subject to mortgage = When the property swapped is real estate, it often will be subject to a mortgage. The outstanding mortgage is treated as cash received and recognized as boot to the extent that it exceeds any mortgage the seller must assume.
• Old basis = AB in old property + debt assumed on new property (everything T gave up).
• AR = FMV of property received + debt relieved on exchange (everything T received).
• New basis = Old basis + recognized gain – recognized loss – cash received.
1) Example = Suppose T owned an apartment building (AB = $50, FMV = $70, Mortgage = $40) which he swapped for a building owned by X (AB = $100, FMV = $80, Mortgage = $50)
a) Result to T = T’s basis the moment before sale is his old basis ($50) + the mortgage assumed ($50), or $100. T’s amount realized is FMV of property received ($80) + relief of mortgage ($40). His realized gain is therefore $20. He does not recognize any gain, however, because the amount of mortgage assumed exceeds the amount of debt of which he was relieved. His basis in the new building is his basis before swap ($100) + recognized gain ($0) – recognized loss ($0) – cash received ($40) = $60. If he immediately sold the property he received at its FMV ($80), he would recognize a $20 gain, which reflects the amount of gain deferred.
b) Result to X = X’s basis the moment before sale is his old basis ($100) + the mortgage assumed ($40), or $140. X’s amount realized is FMV of property received ($70) + relief of mortgage ($50), or $120. His realized loss is therefore $20. He does not recognize the boot b/c there was a loss. X’s basis in the new building is his basis before swap ($140) + recognized gain ($0) – recognized loss ($0) – cash received ($50) = $90. If he immediately sold the property, he would recognize a $20 loss, which reflects the amount of loss deferred.
Note: X would never agree to this transaction in reality, b/c he is forced to defer a loss and that sucks. A party should NEVER agree to a § 1031 transaction when their property has gone down in value b/c he will have to defer the loss. He will always prefer selling the property for cash so that he can recognize the loss immediately, when it is worth more to him b/c of the time value of money.
2) Using cash to pay down the debt = Suppose in the above example that FMV of X’s building is $75, and X pays T $5 in cash to make up for the difference. T won’t like this, because he will have to report a $5 gain even though the mortgages do not run in his favor. So he tells X to take the $5 he would otherwise give to him and pay down the $50 mortgage he will be assuming to $45. Assume further that X’s basis in his old building was $20, so that he realizes a $60 gain on the swap (as opposed to the loss above). He would have recognized a gain of $5 (the excess of the mortgage relieved ($45) over the mortgage assumed ($40)), but instead can use the $5 cash paid to offset the net mortgage, such that he recognizes zero gain.
e. Multiparty like-kind exchanges = There may be relatively few situations where 2 taxpayers simply want to trade property w/ each other. So it is likely that several parties will have to become involved to achieve a like-kind exchange. For example, maybe T wants X’s property, but X doesn’t want to swap b/c his property has gone down in value. X sells to Z so that he can recognize his loss, and Z trades w/ T.
1) Biggs v. Commissioner (p. 667) B owned property that he agreed to transfer to P. B wanted to classify the transaction as a like-kind exchange, so he found a piece of property and arranged for a corporation controlled by his lawyer to buy it. P first contracted to buy the property from the corporation (in order to transfer it to B) and then contracted to receive B’s property. P never actually held title to the corporation property. Court held that the transfers leading to the ultimate like-kind transaction were part of a single, integrated plan. The substantive result was a like-kind exchange which qualified for § 1031 treatment.
2) Step transaction doctrine = The traditional position of the IRS was that multiparty transactions would not qualify for nonrecognition if they had the formal appearance of a sale of property followed by a reinvestment of the proceeds. In recent decisions, however, a series of transactions designed and executed as parts of a unitary plan to achieve an intended result will be viewed as a whole regardless of whether the effect of doing so is imposition or relief from taxation. The series of closely related steps in such a plan are viewed merely as the means by which to carry out the plan and will not be separated.
3) Receipt of cash = A transaction that is structured as an exchange may be recharacterized as a sale if T receives not the property itself but cash that he uses to purchase the property. On the other hand, T may be forced to forego loss recognition if a transaction intended to be a sale is instead deemed to be a like-kind exchange.
4) Delayed exchanges = In order to prevent the tax planning made possible by the use of long delays w/ options to receive cash or non-like-kind property, the Code requires that the like-kind transaction be completed w/in 180 days after T relinquishes the property.
2. Involuntary Conversions = § 1033 = Permits nonrecognition of gain resulting from involuntary conversions, such as where property is taken by eminent domain or destroyed by fire or other casualty. The purpose is to provide relief where T is deprived from further use of his property by forces outside of his control.
a. Like property must be acquired = T must use the proceeds to acquire property similar or related in service or use to the property converted, or, in the case of real estate, to acquire property for business or investment that is of like kind to property condemned by the government.
b. Time limit = T must acquire the new property by the end of the second year following the involuntary conversion. The time limit is extended to 3 years for condemnations of real property used for business or investment.
c. Elective upon receipt of money = § 1033, unlike § 1031, is elective if T has received money rather than property in exchange for the converted property.
3. Sale or exchange of residence = § 121 = Ts who own a personal residence do not recognize a realized gain upon its sale or exchange up to 250K if single and 500K if married. The result is that people are pretty much never taxed on gains from the sale of their homes.
a. Equity concerns
1) Decreases equity = The rule gives preferential treatment to people who have the capital or borrowing power to buy houses.
2) Increases equity = The rule promotes equity b/w home owners and other property owners who hold onto their assets until death in order to avoid taxation on gain—there is evidence that home owners often have to dispose of their homes once they reach an age where they are unable to keep them up. The rule also promotes equity b/w home owners who sell their homes and property owners who make like-kind exchanges under § 1031, by allowing nonrecognition of gain in both cases.
b. Efficiency concerns
1) Changes behavior at the margins = The rule encourages people to dispose of their homes as they approach the cap. The effect of any ceiling or floor is to change the behavior of people at the margins. The rule does not have a cliff effect—an bright-line extreme which would force people to report everything above a certain number, and nothing below it.
2) Encourages over-investment in homes = Failure to tax both profit on sale of house and its use on an annual basis provides a huge incentive to put money into homes. Ts who would otherwise invest in something else (e.g., business) will be discouraged from doing so, since they have to pay taxes annually on profits and report gain upon sale.
Characterization of Gains and Losses
1. Introduction
a. Two classes of gains and losses:
1) Capital = Certain gains called “capital gains” are treated preferentially. Instead of being taxed at the highest marginal rate (40%), capital gains are taxed anywhere from 20% to 28%. Taxpayers therefore always prefer to characterize a gain as capital, rather than ordinary. On the other hand, taxpayers always prefer ordinary losses to capital losses, which are deductible only to the extent that they offset capital gains, with an additional $3,000 of capital losses available to offset ordinary income.
2) Ordinary = Any gain that does not qualify as a capital gain is ordinary gain, which will be subject to taxation at the highest marginal rate applicable to the taxpayer. Taxpayers always want to avoid ordinary gains. On the other hand, taxpayers always prefer to characterize their losses as ordinary losses, which are deductible in full against ordinary income.
b. The policy of preferential treatment
1) Arguments favoring preferential treatment:
a) Capital gains are not income = The most fundamental ground offered for excluding capital gains from the income tax base is that capital gains do not really represent income. They are non-recurring and they often simply reflect changes in the interest rate.
Response = Critics of this argument point out that including only recurring items in income would conflict w/ the notion that the income tax base should reflect differences in people’s ability to pay tax, regardless of when or how they come upon the income. Moreover, to the extent that an asset’s increase in value is due to the interest rate, the owner of the asset still enjoys that increase in value and has greater ability to pay than another taxpayer who does not own similar assets.
b) Bunching = Capital gains preference ameliorates the effects of bunching—the realization rule forces Ts to report capital gains in the year of the asset’s sale that have accrued over a period of years and thus the gain on the sale may be subject to a higher marginal rate than would have applied had the gains been reported each year as they accrued.
Response = Critics point out that this makes sense only if T is in a higher tax bracket on the date of disposition than he was when the income accrued. And this argument fails to take into account the benefit T enjoyed from deferring the tax on the gain until the asset was sold, a benefit which may offset any bunching effect completely.
c) Inflation = In an inflationary period, a portion of the capital gain is inflation rather than real gain and, to the extent it merely reflects the rise in general prices, it does not add to one’s economic purchasing power.
Response = The amount of overtaxation of inflationary gains depends upon the rate of inflation and the period the asset was held. Thus a rate preference solution is poor b/c it bears no relation to either factor. Furthermore, the inflation may be offset by the benefit of deferring the tax on the gain until realization. Finally, it would be hard to defend an adjustment for inflationary capital gains w/o comprehensive income tax adjustments for inflation.
d) Disincentive to risk taking = Taxing capital gains as ordinary income would make investors less willing to make risky investments b/c the tax reduces the expected return.
Response = It is not clear that an income tax would significantly discourage risk-taking if there were full loss offsets to compensate.
e) Disincentive to savings = Taxation of capital gains impinges far more heavily on savings than on consumption, since these gains would tend to be saved. Such taxation is therefore more likely to reduce overall investment than other means of raising revenue.
Response = The concern that capital gains taxation impinges upon savings generally supports taxation based on consumption, rather than income. Furthermore, it is not clear that raising the rate of return on savings would increase the amount of savings, since some Ts save only until they reach their goal of a certain amount.
f) Lock-in = To avoid taxation, Ts will refrain from selling appreciated assets even when the market conditions otherwise favor sales. This lock-in effect reduces liquidity, impairs the mobility of capital, and may lead to broader fluctuations in market prices. A preference for capital gains therefore reduces the tax barriers to shifts in investments.
Response = Most capital gains are never taxed anyway—people often hold onto these assets until they die, enabling heirs to step up the basis to the appreciated FMV under § 1014.
2) Arguments opposing preferential treatment:
a) Dollar of capital gain is same as dollar of other income = Because a dollar of capital gain has the same purchasing power as any other dollar of income, there should be no special tax treatment for capital gain or capital losses. Critics respond that capital gains are different for all of the reasons set forth above.
b) Source of tax complexity = The preferential treatment of capital gains results in a huge degree of complexity, w/ Ts engaging in tax planning to convert ordinary income into capital gain. Critics respond that the IRS is destined to make taxation as complex as possible no matter how we do it.
3) Justification for limitation on losses = If gains are deferred until realized, loss limitations are thought to be necessary to prevent selective realization of losses. Loss limitations are especially necessary for Ts who hedge their investments, discussed below. In order to limit the “cherrypicking” of losses, the code limits them to the amount of realized gains plus $3000.
2. Section 1(h): Reviewing the Different Rates
a. Eighteen month assets = For capital assets held for more than 18 months, the tax rate is 20%. If T is in a 15% bracket, the rate is 10% (otherwise, the capital gains preference would do low tax bracket Ts no good).
b. Twelve month assets = For assets that have been held less than 18 months but more than 12 months, the tax rate is 28%. If T is in a 15% bracket, the rate is 15%.
c. Collectibles = The tax rate on capital assets that are considered collectibles (stamps, antiques, gems, and coins) is 28%. If T is in a 15% bracket, the rate is 15%.
d. Depreciable real estate = The tax rate on the gain on depreciable real estate attributable to depreciation on capital assets is taxed at 25%. The remainder of the gain is taxed at 20%.
e. Qualified small business stock = If T sells qualified small business stock (§ 1202) and elects to exclude 50% of the gain, the remaining 50% of the gain is taxed at the taxpayers normal marginal rate, up to a maximum of 28%.
f. Five year assets = The tax rate on sales of capital assets after December 31, 2000, that have been held for more than 5 years is 18%. If T is in a 15% bracket, the rate is 8%. This will never happen.
3. Defining a Capital Transaction
Three conditions = § 1223
a. Capital asset = The transaction must involve property that is a capital asset.
b. Sale or exchange = The property must be transferred in a sale or exchange.
c. Holding period = The minimum holding period (12 or 18 months) must be met.
4. What is a Capital Asset?
a. Defined by exception = § 1221 = Code defines capital asset broadly to include all property held by the taxpayer w/ certain exceptions. The general exceptions are:
• Stock in trade or inventory of a business, or property that is held primarily for sale to customers in the ordinary course of business.
• Depreciable or real property used in a trade or business.
• Literary or artistic property held by its creator.
• Accounts or notes receivable acquired in the ordinary course of the taxpayer’s trade or business.
• US government publications received from the government at a price less than that which the general public charged.
b. Property held for sale to customers = § 1221 (1) = This section exempts from the definition of capital gain property that is held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.
1) Distinguishing ordinary from investment return = This section attempts to distinguish b/w gains that are the result of an asset’s appreciation over time, and those that are part of a taxpayer’s ordinary and everyday profits. The definition is drafted with a focus on the return of capital, in an attempt to distinguish b/w market and investment return.
2) Determining taxpayer’s purpose
Malat v. Ridell (p. 579) T participated in a joint venture which acquired a 45 acre parcel of land, the intended use of which was in dispute. T claimed that the intention was to develop an apartment project on the land. IRS argued that the property would be developed for rental purposes or selling, whichever was more profitable. When financing difficulties arose, the interior lots were subdivided and sold. The profit was reported and taxed as ordinary income. T continued to explore the possibility of commercially developing the exterior parcels. When he encountered zoning restrictions, he decided to sell his remaining interest in the land. He reported these profits as capital gains. IRS contends that the property should be excluded from capital treatment under § 1221 (1) as property primarily held for sale to customers in the ordinary course of business.
a) Defining primary purpose = District Court ruled that T had failed to establish that his property was not held primarily for sale to customers w/in the meaning of the statute. Court defined “primarily” as meaning “principally” or “of first importance” and remanded the case for consideration under that definition.
b) Change of purpose = Malat has had little impact on lower court determinations of primary purpose. In situations involving change of purpose from rental to sale, lower courts have indicated that the time for determining the taxpayer’s purpose is the time of sale. But it is tautological that at the time of sale, sale is “of first importance” to the taxpayer.
c) Dual purpose = Malat was thought to have the most import in the dual purpose context involving assets held for both rental and sale. Some courts, however, have found two businesses—a rental business and a sales business. Again, it naturally follows that the sale is “of first importance” to the sale business.
3) Determining what counts as dealer property
Byram v. United States (p. 584) T sold 7 pieces of real property. T was not a licensed real estate broker and did not hold himself out as such. He advertised none of the 7 properties for sale, and did not list any of them w/ real estate brokers. T devoted little time to the sales—all of the transactions were initiated either by the purchaser or by someone acting in the purchaser’s behalf. None of the properties sold was platted or subdivided. 6 of the 7 properties were held for intervals just exceeding the applicable holding period. In a two year period, T sold a total of 22 parcels for a net profit of 3.4 million.
a) Seven-factor test = Court announced a seven-factor test for determining whether the sale of property falls w/in the § 1221(1) exclusion. Court concluded that most of the factors were absent in this case.
• Nature and purpose of the acquisition of the property and the duration of ownership.
• Extent and nature of T’s efforts to sell the property.
• Number, extent, continuity, and substantiality of the sales.
• Extent of subdividing, developing, and advertising to increase sales.
• Use of a business office for the sale of property.
• Character and degree of supervision or control exercised by T over any representative selling the property.
• Time and effort T habitually devoted to the sales.
b) Focus on frequency and substantiality of sales = The most important factor cited in many cases is the number, frequency, and substantiality of the sales. Courts suggest that sales that are numerous and that extend over a long period of time are more likely to have occurred in the ordinary course of business, while sales that are few and isolated are more likely to have resulted from investment activity.
c) Seller’s passivity = Courts have also suggested that Ts will seldom be found to have engaged in a trade or business where they have done little, if anything, to acquire, improve, or market their properties.
d) Relative earnings = Where T’s real estate activities produce the bulk of his income, Courts will generally apply the § 1221(1) exclusion, even where his activities in connection w/ the sales were relatively slight.
e) Externally induced factors = Courts have also suggested that capital gains treatment might be appropriate when the change from an investment activity to a sales activity results from unanticipated, externally induced factors which make impossible the preexisting use of the realty. These factors might include acts of God, condemnation of one part of one’s property, or new and unfavorable zoning regulations.
f) Liquidation investments = Courts may be more willing to allow capital gains treatment on sales of real estate where T can establish that he subdivided the property merely to liquidate his investment more profitably.
g) Preserving capital gains treatment = § 1237 = Code establishes conditions under which land will not be deemed to have been held primarily for sale to customers in the ordinary course of business solely b/c it has been subdivided. T must have held the land for a period of at least 5 years. He must not have previously held the land primarily for sale to customers in the ordinary course of business and must not have made any improvement that substantially enhanced the value of the lot or parcel.
4) Stocks and securities = § 1237 = Stock can be either capital or ordinary depending on the holder’s relationship to the asset. Generally, both dealers and traders will be viewed as engaged in a trade or business when they sell securities, while an investor can get capital gains treatment upon the sale of his stock. § 1236 permits dealers to receive capital gains treatment in securities they earmark as investment assets. Most dealers must identify their investment securities by the end of the day of acquisition, while floor traders have seven business days for designation. An ordinary loss cannot be taken on any security that previously has been identified as an investment asset.
5) Hedging = Hedging is a method of dealing in commodity futures whereby a person or business protects against price fluctuations at the time of delivery of the product which it sells or buys. Hedging transactions have consistently given rise to ordinary gains and losses under the inventory exception of § 1221(1).
a) Corn Products Refining Co. v. Commissioner (p. 599) T manufactured products from grain corn. During the Depression, T bought corn futures in order to protect himself against the rising price of corn. T’s contracts became very valuable once the market supply of corn was scarce and the price had risen. T would sell its contracts on the market and buy the corn that it needed to make its products at the higher market price. T was thus able to offset his profits with the higher cost of corn, resulting in less ordinary income than he would have to report if he deducted his actual cost (the lower price of the futures contract). He reported the gain from the sale of the futures contracts as capital gain, since he was not in the business of selling commodities which would give rise to exclusion under § 1221.
i) Example = T bought Ks at $10 per bushel, and FMV of corn ultimately rose to $20 per bushel. T would sell his Ks for $10 and buy the corn that he needed for $20. On a product that he sold for $100, he would deduct $20 cost of corn and report an ordinary gain of $80. If he had taken delivery on his Ks instead of selling them, he would have reported an ordinary gain of $90. Instead, he reports the $10 difference as a capital gain, thus saving tax dollars.
(ii) Business versus investment purpose test = Court conceded that the corn futures did not come w/in the literal language of the exclusions set out in § 1221. But the Court held that the provision should not be read so broadly as to defeat the purpose behind it. Congress intended that profits and losses arising from the everyday operation of a business be considered as ordinary income or loss rather than capital gain or loss. The preferential treatment applies to transactions in property which are not the normal source of business income. The futures in this case were clearly an integral part of T’s business, and the gain from their sale should be taxed as ordinary income.
b) Arkansas Best Corp. v. Commissioner (p. 602) T was a diversified holding company which acquired 65% of a bank’s stock. When the bank began to have problems, T sold its shares and claimed a deduction for an ordinary loss. IRS disallowed the deduction claiming that the loss was a capital loss subject to the limitations of § 1211. IRS claimed that the stock had been purchased for investment rather than business purposes and that, under Corn Products, assets purchased and held for investment purposes give rise to capital gains and losses, while assets purchased for business purposes give rise to ordinary gains and losses.
i) Rejecting motive test = Court rejected the IRS’s reading of Corn Products, although it seemed to follow from the literal language of the opinion. Court held that the itemized § 1221 exclusions would be superfluous if assets acquired primarily or exclusively for business purposes were not capital assets. Consequently, the Court held that a taxpayer’s motivation in purchasing is irrelevant to the asset’s characterization as capital or ordinary. Assets will be considered capital unless they fall under the list of exclusions in § 1221.
(ii) Inventory exception = Court interpreted Corn Products as no more than an illustration of the inventory exception under § 1221. The Corn Products Court found that the company’s futures Ks were an integral part of its business and surrogates for the raw material itself. As such, it concluded that hedging transactions that are an integral part of a business inventory purchase system fall w/in the inventory exclusion of § 1221.
iii) Applied to facts = Despite the Court’s narrow interpretation of Corn Products, it agreed that T’s loss in this case should be capital rather than ordinary. T’s stock fell w/in the broad definition of capital asset in § 1221 and was outside the classes of property exempt from capital asset status.
c) Two part test for business hedges = R 1.1221-1 = Everyone agrees that ordinary income treatment is appropriate for business hedges, but there is less agreement over what constitutes a business hedge. The regulations put forth a two-part test for when ordinary income treatment is appropriate.
i) Must be in normal course of business = First, the transaction must be entered into by T in the normal course of business and must be intended primarily to either (a) reduce the risk of price changes or currency fluctuations w/ respect to ordinary property that is held by T, or (b) reduce the risk of interest rate or price changes or currency fluctuations w/ respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred by the taxpayer.
ii) Must relate to ordinary property = Second, the related asset, liability, or risk being hedged must relate to ordinary property or obligations. Ordinary property is that which could never produce a capital gain or loss if sold or exchanged. The idea is that it would be inappropriate to treat a loss on a hedge as ordinary if the gain on the hedged item could be capital.
c. Depreciable property or real property used in trade or business = § 1221 (2) = The second type of assets excluded from characterization as capital are real and depreciable property used in a trade or business. This section, however, is trumped by § 1231. In turn, § 1231 only applies if the recapture provisions of §§ 1245/50 do not apply. So, when dealing with § 1221 (2) property, take three steps:
• Note that you are dealing w/ property which would technically be excluded from capital treatment under § 1221 (2)
• Apply the recapture provisions of §§ 1245/50, if they are applicable.
• Apply § 1231 to determine the amount of capital and ordinary gains/losses.
1) Recapturing excess depreciation = §§ 1245/50 = If depreciation accurately measured the actual decline in value of an asset, T’s basis would be approximately equal to FMV and a sale would produce neither a gain nor loss. The code, however, allows for accelerated depreciation. When T realizes a gain on depreciated property, he has been permitted to take depreciation exceeding the economic cost of holding the asset.
a) Tangible personal property = § 1245 = If T were able to enjoy depreciation deductions (which offset ordinary income) and capital gain treatment on sale via § 1231, he would be able to convert ordinary income into capital gain. He would be depreciating at his highest marginal rate, and paying back the depreciation at a capital gains rate. § 1245 prohibits this by requiring the recapture of previously deducted depreciation as ordinary income. The ordinary gain reported pays back the excess depreciation, although T has enjoyed the time value of the earlier deductions.
i) Example = T purchases a machine for 10K and takes 4K of depreciation. He then sold the machine for 11K. While the increase in market value is only 1K over T’s basis, T reports a 5K gain (4K depreciation + 1K market appreciation).
ii) Does not apply to losses = Assume T sold the machine for 3K. His adjusted basis in the property was 6K (10K cost – 4K depreciation), so he has a loss of 3K. In this case, he did not depreciate enough so there is no need for recapture. His loss will be capital. T, like the government above, loses out on the time value of the amount which he should have deducted at an earlier date.
b) Real property = § 1250 = This section provides a comparable, but less complete, recapture mechanism for dispositions of real property. It recaptures the excess of accelerated depreciation over straight-line depreciation on certain real estate. Since, however, real estate currently is only depreciated using the straight-line method, there is no § 1250 recapture on property that has only been allowed straight-line depreciation.
2) Mechanics of § 1231 = This section is tax nirvana. By giving capital gains treatment to what were supposed to be ordinary income assets, § 1231 allows real and depreciable property used in a trade or business to yield capital gain when disposed of at a gain and ordinary loss when disposed of at a loss. There is no modern day reason for this (§ 1231 was enacted to deal w/ property crises in WWII), but Ts aren’t complaining.
a) Quasi-capital assets covered = § 1231 applies to all property that would fall under the § 1221(2) exclusion—land, buildings, machinery, and fixtures. It also applies to livestock, timber, coal, minerals, and unharvested crops sold w/ the land. The property must have been held by T for at least one year. These “quasi-capital assets” do NOT include other business assets that are denied capital treatment by § 1221, like inventory, copyrights, artistic compositions, and government documents obtained below cost.
b) Three types of dispositions covered = There are 3 types of dispositions that may give rise to § 1231 treatment:
• Sales and exchanges of property used in a trade or business.
• Condemnations and involuntary conversions of property (e.g., theft or casualty) used in a trade or business.
• Condemnation and involuntary conversions of capital assets held in connection w/ a trade or business or in a profit-seeking activity that falls short of a trade or business.
c) Two-stage netting process = § 1231 requires a two-stage netting process:
i) Firepot = First, T nets her gains and losses from casualty and theft losses (from insurance proceeds) against her losses from such involuntary conversions. If losses exceed gains, § 1231 does not apply to either the losses or the gains. There is deemed to be no sale or exchange, so the gains are taxable as ordinary income and the losses are deductible as ordinary income. If gains exceed losses, however, both gains and losses are carried over to the second stage of the netting process. The first stage is called the “firepot” b/c it deals w/ conversions from fire, storm, or other casualty.
(ii) Hotchpot = Second, T compares her total gains w/ her total losses from the firepot, and from condemnations, sales and exchanges of business property. If losses exceed gains, the gains are included in ordinary income and the losses are deducted from ordinary income. If gains exceed losses, however, the gains are treated as long-term capital gains and the losses are treated as long-term capital losses. The result is that net losses are treated as ordinary and net gains are treated as capital, yielding a net benefit either way.
iii) Example = In the firepot, T puts a 50K loss on property destroyed by fire and a 10K loss on uninsured stolen equipment, for a net loss of 60K. Because there is a net loss, T gets an ordinary deduction. Yippee. T then goes to the hotchpot, where he puts a 100K gain from the sale of business real estate, 5K loss from the sale of a business truck, and 5K gain on the condemnation of real property. There is a net gain of 100K, so everything is treated as capital. Even though T must treat the 5K loss as capital, he benefits overall b/c the 105K gain is treated as capital. Yippee again.
d. Copyrights, literary, musical and artistic compositions, and patents = § 1221 (3) = The third group of exclusions under § 1221 contains copyrights, literary, musical and artistic compositions, and letters or memoranda prepared by or for the taxpayer.
1) Applies only to creator = The exclusion from capital gains treatment is limited to dispositions of property held by its creator or by a taxpayer whose basis is determined by reference to the creator’s basis (e.g., the recipient of a gift or a corporation controlled by the creator). Copyrights and literary, musical or artistic creations are capital assets, however, in the hands of buyers or legatees unless they are held for sale to customers in the ordinary course of trade or business.
2) Equity rationale = § 1221 (3) creates parity b/w one who is paid for his services in creating artistic composition and one who sells the actual composition. The painting is viewed as the painter’s inventory. More generally, the section creates parity b/w people who sell their services, and those who can turn their services into property.
e. Accounts and notes receivable = § 1221 (4) = The fourth exclusion from the definition of capital assets applies to accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property held for sale to customers in the ordinary course of business.
f. Government documents received free or at discount = § 1221 (5) = Finally, government publications received by Ts w/o charge or at a reduced price are excluded from categorization as capital assets. An example would be copies of the Congressional Record received free by a member of Congress.
Connection to § 170 (e) = Together w/ § 170 (e), § 1221 (5) works to deprive Ts of charitable deductions at FMV of free or discounted materials when they contribute them to a charity such as a university or library.
1) Deduction limited to basis in property = If the property is not used by the recipient in its charitable function, then the donor’s deduction is limited to his basis in the property. This did not remove the incentive for abuse entirely—many charities could display congressional records or hang ugly art so that their donor’s could get a full FMV deduction. So a second limitation applies.
2) Deduction limited to amount not characterizable as long-term capital gain = Regardless of whether the property is used by the recipient, the donor’s deduction is limited to FMV minus the amount of gain that would not have been long-term capital gain if he had sold the asset. This removes the benefit of giving away appreciated ordinary income property to a charity.
5. What Counts as a Sale or Exchange?
a. Rationale behind the requirement = The sale or exchange requirement arose b/c of the concern about the lock-in problem. Ts are thought to be more likely to dispose of their assets if given an incentive to do so.
b. How the requirement is used = Courts do not always address the issue of what counts as a capital asset apart from the issue of whether a sale or exchange has occurred. Courts seem to invoke the sale or exchange requirement to prevent favorable capital gains treatment when it seems inappropriate. The requirement has also been viewed as a means of preventing the conversion of interest, dividends, and the collection of rent on property (all of which are examples of ordinary income) into capital gain.
c. Dispositions of leases
1) Hort v. Commissioner (p. 612) T acquired office building and leased it to a firm. Lessees wanted to get out of the lease, so he negotiated w/ T for a settlement. T did not include settlement in income. He reported an ordinary loss—the difference b/w what he would have received from the fulfillment of the lease and the amount of the settlement. Court presumed that T received the present value of the future rental stream as a settlement. Court held that he had ordinary income in the amount of the settlement.
a) Substitute for ordinary income standard = Court characterized the lump sum payment for cancellation of the lease as a substitute for the relinquishment of the right to future rent and thus concluded that T had ordinary income. Should we interpret this to mean that the sale of the right to an income stream that would otherwise have been reported as ordinary income can never produce capital gain? This would seem like a bad test. The value of an asset always reflects the value of the income stream that it is expected to produce—the expected income stream is capitalized in the price.
b) Landlords selling premium leases = In premium leases, changes in the economy make the lease more valuable to the lessor at the time of cancellation than at the time that the lease was entered into. In that situation, L relieving T of his obligations under a lease would receive more than the present value of the rental stream. The entire amount received is not a substitute for the rent due—the premium represents market appreciation, which should theoretically receive capital gains treatment. The Court ignored this.
c) Tenants selling premium leases = Assume that the market has changed the value of a lease such that T is paying a rent substantially lower than the FMV. T sells his lease for a premium, and reports a capital gain. T is treated differently from L, because T’s sole asset was the income stream which he was relinquishing. By contrast, L keeps the underlying asset and retains the right to a substitute income stream. If the only thing that you have is an income stream, then it is treated as a capital asset when you sell it.
2) Metropolitan Building Co. v. Commissioner (p. 613) University of Washington leased a city block to M, which leased the block to H. In order to obtain more favorable lease terms, H wished to rent directly from the university. H paid M a sum of money greater than the foregone rental payments to M in consideration for its release of all rights and interests in its lease w/ the university. Court treated the payment to M as a capital gain, b/c the transaction was a transfer of the leasehold in its entirety. The case was not one of a liquidation of a right to future income as in Hort, but was the disposition of income-producing property itself.
d. Abandonment or extinguishment of rights
1) Yarbro v. Commissioner (p. 649) T held property subject to a non-recourse mortgage. During a time of increased real estate taxes and a poor market, the property’s FMV dropped below the face value of the mortgage. T thus abandoned the property and claimed an ordinary loss. IRS contended that T’s abandonment constituted a sale or exchange, that the land was held by T for investment purposes, and, consequently, that the abandonment was a sale or exchange of a capital asset that would give rise to an ordinary loss under § 1221.
a) Defining exchange = Court defined “exchange” as the act of giving up one thing in return for another regarded as equivalent. Here, T gave up property in return for a relief of his obligation to pay the debt to which the property was subject.
b) Abandonment constituted sale or exchange = Court therefore held that the abandonment constituted a sale or exchange w/in the meaning of § 1221. If cases of abandonment, foreclosure, and quitclaims did not trigger capital losses under § 1221, then everyone facing a loss on property would abandon it in order to avoid sale (and take an ordinary loss). Where T would be eligible for capital gains treatment upon the sale of property had it appreciated in value, he should not be allowed to avoid the limitations on deductions for capital losses by using an artfully timed abandonment rather than a sale.
e. Repayment of loans
National Standard Co. v. Commissioner (p. 654) T borrowed Belgian francs to buy a foreign asset and later repaid the loan after selling the asset. Between the date of the loan and the repayment, the value of the franc had appreciated w/ respect to the US dollar. Court ruled that although francs constituted a capital asset in the hands of T separate from the asset they were used to buy, the repayment of the loan did not constitute a sale or exchange. As a result, T was allowed to take an ordinary loss deduction for the additional dollars that he needed to discharge the debt.
f. Sale or extinguishment of contract rights
Foote v. Commissioner (p. 654) T resigned his tenure appointment to a university faculty in exchange for a cash payment. Court ruled that even if his tenure had significant economic value and could have been considered an intangible capital asset, the voluntary extinguishment did not constitute a sale or exchange, b/c the asset disappeared upon payment and could not be transferred to anyone else. See also Rev. Rule 75-527.
VI. Accounting
A. Introduction
1. Two methods of accounting:
a. Cash method = Items are included in income in the year in which they are received, and deducted in the year in which they are paid. Most individuals and small businesses use this method, which is simpler than the accrual method. Its disadvantage is that it fails to measure income accurately when T’s activities is more complex.
b. Accrual method = Items are included in income in the year in which they are earned, regardless of when they are received, and taken as deductions in the year in which they are incurred, regardless of when they are paid. Most corporations and a few individuals use this method, which is thought to give a more accurate reflection of economic gain. Regulations mandate accrual method when inventories are required. Accrual method does NOT apply to:
• Qualified personal service corporations (law, accounting, consulting, engineering, architecture firms).
• Subchapter C corps and partnerships which average less than 5 million in gross receipts annually over period of 3 taxable years b/f the year in question.
2. General rule for accounting = § 446 = T shall compute taxable income under the method of accounting which T regularly uses in keeping his books so long as that method clearly reflects income.
a. General rule for inclusions = § 451 = Default method for inclusions is the cash method—Ts should include items in gross income in taxable year of receipt unless their method of accounting requires that the income be included in a different taxable year.
b. General rule for deductions = § 461 = No default method for deductions—Ts should take deductions under the method of accounting used in computing taxable income.
B. Cash Method
1. Constructive Receipt Doctrine
a. Defined = R 1.451-2(a) = Property and services are taxable to cash method Ts when actually or constructively received. The constructive receipt doctrine requires inclusion of income when T has the immediate power to receive the income. Income is not constructively received if T’s control of its receipt is subject to substantial limitations or restrictions.
b. Purpose of constructive receipt = Doctrine developed to prevent Ts from choosing the year in which to return income merely by choosing the year in which to reduce it to possession. Treasury therefore may subject income to taxation when the only thing preventing its reduction to possession is the volition of T.
c. Carter v. Commissioner (p. 717) T performed services as lab technician in 1974. Due to a backlog in processing, he did not receive payment for the services until 1975. He reported the income as received in 1974, in order to avoid the payment of additional taxes which would result if he did not report the income until 1975. He contended that he constructively received the income in 1974, b/c the work was performed in 1974. Court disagreed—T did not have free and unrestricted control of his wages prior to actual receipt. The presence of the funds in NYC budget was not enough.
d. Delaying payment by contract
Schniers v. Commissioner (p. 719) Court upheld a deferred payment arrangement entered into in 1973, whereby a cotton farmer delayed until 1974 receipt of income from crops harvested and warehoused in 1973. Commissioner argued for constructive receipt on grounds that deferred payment contracts were entered into voluntarily by T for sole purpose of delaying income. Court upheld K, concluding that T was not required to sell the crops in the year in which he harvested them. T does not have constructive receipt merely b/c he could have entered into an arrangement to receive payment earlier.
2. Receipt of Cash Equivalents
a. Cash equivalence doctrine = Unlike the constructive receipt doctrine, the cash equivalence doctrine requires the actual receipt of property or of a right to receive property in the future. This doctrine inquires whether the property or right received confers a present—and often marketable—economic benefit. The problem is generally one of deferred compensation. Courts are uniform in holding that a cash equivalent is taxable upon receipt, but there is disagreements as to what types of property interests are cash equivalents.
b. Checks = Checks, which are mechanisms for making payments rather than promises to pay, are generally treated as cash. So checks are treated as income when they are received. This is true even if where T does not have the ability to turn it into cash immediately upon receipt (e.g., the bank is closed).
c. Notes = A note is treated as a cash-equivalent where a solvent obligor makes a promise to pay which is unconditional and assignable, and where the note is of a kind frequently transferred b/w lenders and investors. The note will NOT be treated as a cash equivalent if the obligor has insufficient funds to satisfy his debt or if the note would be denied ready acceptance in the marketplace (Cowden).
d. Accounts receivable = Accounts receivable, some notes, and other debt instruments are not included in income when received by a cash method T. Requiring all debt instruments to be included immediately in income would obliterate the fundamental distinction b/w the cash and accrual methods of accounting.
3. Economic Benefit Doctrine = Although courts often refer separately to the economic benefit doctrine, the distinction b/w it and both the cash equivalence and constructive receipt doctrines is unclear.
Pulsifer v. Commissioner (p. 728) Father and his three kids won Irish Hospital Sweepstakes. Funds were deposited in a bank account until the kids reached 21 or until their legal representative applied for release of the funds. Court held that they were taxable under the economic benefit doctrine on “the economic and financial benefit derived from the absolute right to income in the form of a fund which has been irrevocably set aside.
4. Payments
a. Payments made by borrowing from third parties = Cash basis T can usually deduct payments made w/ funds borrowed by a third party (e.g., paying by credit card).
b. Payments by delivering a note = Transfer of T’s own note does not constitute payment.
1) Helvering v. Price (p. 731) Court held that a secured not satisfying T’s guaranty obligation did not give rise to a deduction b/c it was not the equivalent of cash.
2) R 1.446-1(c)(1) and Rev. Ruling 70-647 = Expenditures are deductible by cash basis Ts for the year in which actually made. The payment required as a basis for deduction by a cash basis T is the payment of cash or its equivalent, and the giving of T’s own note is not equivalent of cash entitling T to deduction.
3) Notes treated differently for income versus deduction = The test for whether a note is income to a cash basis T is different from the test for whether it constitutes payment. This is illustrated by Rev. Ruling 76-135, in which a client paid a lawyer w/ a negotiable promissory note. The ruling held that the cash basis lawyer, who discounted the note at a bank, had income on the discounted value of the note when received. The cash basis client, however, only had a deduction when he made the actual payment to the bank.
5. Prepayments—Expenses paid in advance
a. Capital expenditures = R 1.461-1(a) = A cash basis T cannot deduct the cost of a capital asset merely b/c she paid cash for it. If an expenditure results in the creation of an asset having a useful like which extends substantially beyond the close of the taxable year, such an expenditure may not be deductible, or may be deductible only in part, for the taxable year in which made.
1) Commissioner v. Boylston Market (p. 733) Cash basis T purchased 3-year insurance policy for its real estate management business. T deducted each year as insurance expenses the amount of insurance premiums applicable to carrying insurance for that year, regardless of the year in which the premium was actually paid. Court held that the purchase of the policy created a capital asset which had a life extending beyond the taxable year. T therefore had to recover its expenses over the corresponding period and could not deduct the premiums in full at the time they were paid.
2) Zaninovich v. Commissioner (p. 735) Court adopted a on-year guidepost to determine whether an expenditure results in the creation of an asset having a useful like extending beyond the end of the taxable year. Under this formulation, prepayments generally may be deducted if they do not provide benefits that extend beyond the taxable year.
b. Interest = § 461 (g) = Cash method Ts must allocate and deduct prepaid interest over the loan period, in effect, putting cash method Ts on the accrual method for interest deductions. This rule applies to all prepayments of interest, whether on a business or investment debt or on a home mortgage.
Accrual Method
1. All Events Test = § 461 (h)(4) = The “all events” test is the general test for determining whether items of income and deduction have accrued for tax purposes. The statutory definition provides that the all-events test is met w/ respect to a deductible item if all events have occurred which determine the fact of liability and the amount of such liability can be determined w/ reasonable accuracy.
2. Accrual of Income
a. Rev. Ruling § 83-106 = For the accrual T, it is the right to receive an item of income and not the actual receipt that determines the inclusion of the amount in gross income. The all-events test for income is comprised of 2 prongs:
1) Right to receive income is fixed = First, all the events must have occurred which fix T’s right to receive the income. A fixed right to receive income occurs when:
• Required performance takes place.
• Payment is due.
• Payment is made.
2) Amount of income determinable = Second, the amount of income due to T must be determinable w/ reasonable accuracy.
3) Exception to all events test = An exception to the all events test is that a fixed right to a determinable amount does not require accrual if the income is uncollectible when the right to receive the income arises. Stated differently, the accrual of income is not required when a fixed right to receive arises if there is not a reasonable expectancy that the claim will ever be paid. Substantial evidence as to the financial instability or even the insolvency of the debtor must be presented for this exception to apply.
b. Notes with no ascertainable market value = Where accrual Ts accept notes as payment, the entire face value of the note accrues as income, even where the notes are not assignable and have no ascertainable market value. This is b/c the right to receive the face amount of the note fixes the accrual Ts income. Cash basis Ts, on the other hand, will be allowed to include only the FMV of the note in gross income.
3. Prepayment for unearned income = A much disputed issue is when an accrual T must include in income amounts that actually have been received but have not yet been earned. Accounting principles would indicate deferral, or that the income is properly accrued when earned by delivery of goods and services. IRS has taken the position, however, that such amounts are income when received.
RCA Corp. v United States (p. 748) Purchaser of RCA products would contract, at time of purchase, to receive service and repair of product for a stated period in exchange for prepayment of a single lump sum. Under these agreements, service was available to purchaser on demand at any time during the contract term. For each group of service contracts, RCA would credit to current income a sum that represented the actual cost of selling and processing the contracts, plus a profit. The balance of the revenues derived from each group of contracts—the portion to be earned through future performance under them, was credited to a deferred income account. Each month thereafter, RCA reported from the deferred income account to current income that proportion of the revenues from each group of contracts that it estimated had been earned in the month through actual performance. The forecasts were not perfect, but they matched service contract revenue and related expenses w/ reasonable accuracy.
a. Deferral of unearned income disallowed = Relying on a trilogy of Supreme Court cases—Michigan, AAA, and Schlude—the Commissioner rejected the accrual method of reporting income only once it accrued upon performance of services as not “clearly reflecting income” under § 446(b). Court held noted that, when T receives income in the form of prepayment for services to be performed in the future upon demand, T cannot know w/ reasonable certainty the amount of service that the customer will require. T should therefore report the income when he has it—upfront. The result is that the accrual T is put on the cash method in cases involving prepayment for future services.
b. Exception = Where the time and extent of future services can be determined with extreme accuracy, the limitation may not apply. In Artnell v. Commissioner (p. 754), for example, Court sustained T’s deferral of income from prepayment for White Sox tickets on the grounds that the time and extent of the future services were so definite that T’s method clearly reflected income and that the Commissioner’s refusal to permit deferral would be an abuse of discretion under § 446.
4. Expenses
a. Economic performance limitation = § 461 (h)(1) = The timing of the deduction for the accrual method T turns on the all events test, as does the timing of income accrual. With regard to deductions, however, the all events test is not deemed satisfied until there is economic performance.
1) Rationale = IRS believed that the rules relating to the time for accrual of a deduction should be changed to account for the time value of money. Allowing T to take deductions currently for an amount to be paid in the future overstates the true cost of the expense to the extent that the time value of money is not taken into account. The deduction is overstated by the amount the face value exceeds the present value of the expense.
2) What counts as economic performance = Economic performance w/ respect to a particular liability generally occurs when the activities that T is obligated to do to satisfy the liability actually are performed.
a) Services or property provided to taxpayer = R 1.461(d) = If T’s liability arises out of the provision of services or property to T by another person, economic performance occurs as the services or property is provided. This puts the RCA-like taxpayer in a horrible position—he has to report prepaid income for future services upfront, and cannot take a deduction for his expenses until the services are actually performed.
b) Certain liabilities for which payment is economic performance = R 1.461 (g) = For certain liabilities, economic performance occurs when and to the extent that payment is made to the person to whom the liability is owed. In these cases, accrual Ts are treated just like cash method Ts:
• Liabilities arising under tort, breach of contract, or violation of the law.
• Rebates and refunds.
• Awards, prizes, and jackpots.
• Insurance, warranty, and service contracts.
• Taxes
3) Recurring items exception = The principal exception to the economic performance rule is for recurring items. T may deduct expenditures for recurring items as soon as the traditional all events test is met, so long as economic performance occurs no later than 8 ½ months after the close of the taxable year and either the item is immaterial or all events accounting results in a better marching of the liability w/ income to which it relates than would result from accruing the liability when economic performance occurs. E.g., if T is performing services every 3 months, he can take deduction when he is paid upfront b/c time lag is so small.
b. Ford Motor Co. v. Commissioner (p. 764) This case arose before the economic performance limitation of § 461 (h) applied, but illustrates the problems associated w/ allowing accrual Ts to deduct their expenses when technically incurred. Ford entered into structured settlement agreements to resolve personal injury or accidental death claims. It purchased single premium annuity contracts, structured so that yearly annuity payments to be received under the contracts would equal yearly amount of deferred payments owed to tort claimants. Ford would deduct the total future payments under its obligations to the tort claimants upon purchase of the contracts, even though the obligations would not be paid out for years into the future (up to 58 years). Result was that Ford actually made money off of its tort claimants, by taking huge deductions upfront, investing the tax savings, and pocketing the growth on the investment that exceeded its liability to the tort claimants.
Interest
1. Importance of proper timing = With annuities, we allow Ts to arbitrarily treat a pro-rata amount of the monthly payment as interest. This is clearly inaccurate. The interest on a loan, for example, can’t possibly be the same amount over the payment period—each month, T pays interest on the compounded interest that he has not yet paid resulting in increasing interest over time. The Code requires T to identify the economic interest element in a transaction, rather than accepting arbitrary estimations as we do w/ annuities, for 3 reasons:
• Takes into account time value of money.
• Income is taxed as ordinary income and must be distinguished from appreciation in value of assets over time, which is often eligible for favorable capital gains treatment.
• Interest income and expense must be allocated to the proper T to prevent shifting of income among Ts subject to different tax rates.
2. Stated Interest = Where the interest is stated on the debt instrument, the amount of interest is not in dispute, and the only question is when the interest should be reported in income by the lender, and when it should be deducted by the borrower.
a. Cash method = A cash method borrower deducts interest when he pays it, and a cash method lender reports interest income upon receipt.
b. Accrual method = An accrual method borrower deducts interest in the taxable year in which it accrues, and an accrual lender reports interest income in the taxable year in which it is owed to him. When payment occurs is irrelevant—the passage of time fixes the obligation.
c. Matching required for related taxpayers = § 267 = Where a cash-method T lends money to a related accrual method T, they could theoretically take advantage of the tax system. The loan could be arranged such that the accrual method T could deduct interest in one year, while the cash method T would not have to report interest income until a later year. Because the Ts are one economic unit, they get away w/ the time value of the deferred income. § 267 prevents this by requiring the matching of the borrower’s deduction and the lender’s income when the parties are related—T cannot take a deduction for interest until the related party includes it in income.
3. Unstated Interest—Original Issue Discounts (OID)
Where there is clearly interest on an loan, but the interest is unstated on the face of the debt instrument, different rules apply.
a. Defined = § 1273 = Original issue discount (OID) exists when the original issue price of a debt instrument is less than the amount to be paid at maturity. OID is typically present when bonds are issued w/ no interest payable currently (zero coupon bonds) or a below-market interest rate payable currently. The difference b/w the amount received by the borrower (“issue price”) and the amount to be repaid (“stated redemption price”) is compensation to lender for use of money and is functionally equivalent to an increase in stated rate of interest.
b. Current inclusion of OID = § 1272 = If a debt obligation is identified as containing OID, the imputed interest is required to be included in income and deducted annually on an economic accrual basis, whether or not paid.
• Lender is required to include daily portions of OID in its income for each taxable year that it holds the bond, and the borrower deducts the same amount as interest.
• OID for each period is determined by multiplying the adjusted issue price at the beginning of the period by the yield to maturity.
• OID that is reported for each accrual period is added to the adjusted issue price of the bond.
• Generally, the accrual period is 6 months.
c. Example #1 = On January 1 of Y1, C (cash basis T) purchases XYZ bond w/ face value of 10K for $7,462. Redemption date is January 1 of Y4. There is no stated interest. Assume a yield to maturity at 10% compounded semi-annually.
|Accrual period ending |Adjusted issue price |Yield to maturity |OID |
|June 30, Y1 |$7462 |.05 |$373 |
|January 1, Y2 |$7835 |.05 |$392 |
|June 30, Y2 |$8227 |.05 |$411 |
|January 30, Y3 |$8638 |.05 |$432 |
|June 30, Y3 |$9070 |.05 |$454 |
|January 1, Y4 |$9524 |.05 |$476 |
Redemption = $10,000
OID for Y1 is $765, for Y2 is $843 and for Y3 is $930, for a total of $2538, the difference b/w the issue price and the redemption price. C reports OID in the above amounts each year, and XYZ deducts identical amounts.
d. Example #2 = The example changes slightly where there is some stated and some unstated interest. The stated interest is subject to the normal cash and accrual rules, while the OID is subject to § 1272. Assume that the redemption price of the note above is $8,300. XYZ is required to pay $250 every six months including the final period.
|Accrual period ending |Adjusted issue price |Yield to maturity |(AIP x YTM) – Stated |OID |
| | | |interest | |
|June 30, Y1 |$7462 |.05 |$373 – 250 |$123 |
|January 1, Y2 |$7585 |.05 |$379 – 250 |$129 |
|June 30, Y2 |$7714 |.05 |$386 – 250 |$136 |
|January 1, Y3 |$7850 |.05 |$393 – 250 |$143 |
|June 30, Y3 |$7993 |.05 |$400 – 250 |$150 |
|January 30, Y4 |$8143 |.05 |$407 – 250 |$157 |
Redemption = $8300
OID for Y1 is $252, for Y2 is $279, for Y3 is $307, for a total of $838, which represents the difference b/w the issue price and the redemption price.
4. Low-interest or interest-free loans = § 7872
a. Purpose = Ordinary people don’t just let people borrow money for free, or at very low rates of interest when they have nothing to gain from the deal. The purpose of § 7872 is to identify transfers that are attempting to hide disguise interest so that the borrower doesn’t have to pay it, and the lender doesn’t have to report it.
b. To whom § 7872 applies = Rules of § 7872 precludes the use of interest-free or low-interest loans b/w:
• Employer lends money to employee—to avoid employment taxes or limitations on interest deductions.
• Family member lends money to another family member—to shift income from high-rate Ts to low-rate Ts.
• Corporation lends money to shareholders—to disguise dividends.
c. To what loans § 7872 applies = Rules of § 7872 apply to transactions when:
• Loan is made in form of cash.
• Loan is interest-free.
• There is stated interest, but it is below the applicable federal rate (AFR), which is a set rate chosen to reflect the market rate of interest at the time.
• There is OID, but when the amount is below the AFR when discounted.
d. Two types of § 7872 transactions = The rules of § 7872 vary according to whether the loan is a term loan or a demand loan.
1) Term loan = § 7872 (e) = A term loan is one which fixes the repayment of the obligation to occur over a set number of years. A term loan is a below-market loan if the amount loaned exceeds the present value of all payments to be made under the loan, using the AFR as the date the loan is entered into as the discount rate. § 7872 recharacterizes the loan such that a portion of the amount will reflect principal, and the remainder will reflect interest at the AFR.
a) Treatment of lender = On the date of the loan, the lender is treated as having transferred cash equal to the amount loaned over the present value of all payments required to be made. The latter amount becomes the issue price of the obligation, which will be less than the redemption price, creating OID.
b) Treatment of borrower = The borrower is treated as paying interest at the statutory rate for each accrual period; this results in income that is taxed to the lender on an economic accrual basis, and a deduction for the borrower (depending on how the proceeds of the loan are used).
c) Tax consequences = The lender benefits from the time value of money by realizing interest over the life of the loan, as opposed to upfront. The borrower is at a disadvantage, since he is required to realize the entire amount of income upfront.
d) Examples = Two types of § 7872 loans qualify as term loans:
i) Employer to employee = Assume that an employer (ER) loans an employee (EE) 100K to be repaid at the end of 4 years. There is no interest stated. Assume that the applicable federal rate is 10% compounded semi-annually. The relevant question is what number you will need to invest over a period of 4 years at 10% interest in order to get 100K—the answer is $74,620.
aa) Year of loan = In Y1, ER is treated as loaning $74,620 to EE, which results in no tax consequences for either party. The remaining $25,380 is treated as compensation. ER will deduct $25,380 as compensation paid, and EE will report $25, 380 as income earned.
ab) Years before repayment = In Y1-Y3, interest will accrue on $74, 620, compounded every 6 months to create OID. ER reports as interest income the amount of OID received each year, and EE may be able to deduct the OID as interest paid. OID will be deductible by EE only if he used the loan for trade or business purposes as an employee, or if he used it for investment purposes. Note that in Y1, ER and EE must account for both the compensation component of the loan, and the interest attributable to Y1.
ac) Year of repayment = In Y4, EE repays $74, 620 to ER and there are no tax consequences—the interest has already been accounted for.
ii) Corporation to shareholder = Use the same numbers, but assume change the lender to a corporation (C) and the borrower to a shareholder (SH).
aa) Year of loan = In Y1, C is treated as loaning SH $73, 620 which has no tax consequences. The remaining $25, 380 is treated as a dividend payment. ER has no deduction for dividends paid, EE has income in the amount of dividends received.
ab) Years before repayment = In Y1-Y3, interest will accrue on $74, 620, compounded every 6 months to create OID. C reports as interest income the amount of OID received each year, and SH may be able to deduct the OID as interest paid. OID will be deductible by SH only if he used the loan for trade, business, or investment purposes. Note that in Y1, C and SH must account for both the compensation component of the loan, and the interest attributable to Y1.
ac) Year of repayment = In Y4, SH repays the $74, 620 to C, and there are no tax consequences. The interest has already been accounted for.
2) Demand loan = § 7872 (f) = A below-market demand loan is one in which the interest payable on the loan is less than the AFR. Under § 7872 (a), for each taxable year the loan is outstanding, the amount of interest that would have been payable if the interest had been the AFR is treated as if it had been transferred by the lender to the borrower and then retransferred to the lender as interest.
a) No gift loans between family members = The primary example of a below-market demand loan is a parent’s gift loan to a child. Assume that mom (M) loans kid (K) 100K, payable on demand. AFR is 10% compounded semi-annually. In Y1, interest at the first six months is 5K and interest at the second six months is $5, 250, for a total of $10, 250. M is treated as giving K $10, 250—which is not deductible by M nor includible by K. K is then treated as giving $10, 250 back to M, who will have to report this amount as interest income. K may or may not have a deduction depending on the purpose for which he used the borrowed funds. When the 100K is repaid, there are no tax consequences because there is no interest outstanding.
b) Where § 7872 (f) inapplicable = § 7872 does NOT apply to loans to charitable foundations, and it does not apply where parents make gifts to their children. § 7872 does NOT say that there is no such thing as a gift; it only says that there is no such thing as a gift loan.
5. Installment sales = § 453
a. Purpose = Where T sells appreciated property to a buyer and receives notes as payments instead of cash, there may be a liquidity concern in imposing tax on the gain immediately—T has not received cash or other property, but merely the right to receive cash in the future. Where at least one payment is to be received in a year after sale, § 453 permits sellers to defer payment of tax by spreading the gain over a number of years, treating a portion of each payment as gain and a portion as recovery of T’s basis in the property.
b. Where applicable:
• Installment method is available is available to any nondealer who sells real property or noninventory personal property if payment of at least part of the purchase price is deferred to a future year.
• Applies ONLY where seller has recognized a gain.
c. Where inapplicable:
• § 453 does NOT apply to any installment obligations arising from the sale of stock or securities that are traded on an established securities market, the sales of other property of a kind regularly traded on an established market, and from sales under a revolving credit plan.
• § 453 also does NOT apply to dealers in personal or real property.
• Installment method does NOT apply to losses.
d. What § 453 tells us:
• Tells T when to report the gain on property sold on deferred payment plan ( as T receives payments on notes.
• Tells T how much of the gain to report ( gives T a formula which allocates a portion of every payment to recovery of basis and a portion to realization of gain.
e. Formula: Reportable gain = Payment x (Gross profit ( K price)
1) Payment = Any cash, notes, or other property received constitute payment.
2) Gross profit = Gross profit is the gain, or AR – AB.
3) K price = Contract price is the total amount paid for the property—cash received + face value of the notes.
4) Result = Seller benefits b/c of time value of money—instead of reporting all of the gain upfront upon sale and receipt of the notes, he spreads out realization of gain over the term of repayment.
5) Example = Assume that T sells Blackacre (AB = 400K), for 800K payable over 8 years in 100K. Assume adequately stated interest. His reportable gain = 100K x (400 gain ( 800 K price). The result is 50% of each 100K payment is reported as gain each year. 50K over 8 years adds up to his total gain of 400K. T was able to report his gain over a span of 8 years instead of when he received the right to receive it.
f. Mortgages
1) Payment = Where the property being sold is subject to a mortgage, the buyer’s assumption of the debt is treated as payment in the year of sale only to the extent that it exceeds the seller’s adjusted basis in the property.
2) Gross profit = The mortgage is included in the selling price for purposes of calculating the gross profit
3) K price = The contract price does not include the mortgage except to the extent that it exceeds the seller’s adjusted basis, thus generally reflecting cash payments.
4) Result = The effect of these rules is to permit the seller to offset the entire basis against the mortgage, thus allocating more (or all) of the gain to the cash payments.
5) Example = Assume X owns Blackacre in which he has a basis of 400K (100K cash + 300K mortgage). Y will assume the mortgage and transfer 500K in notes, payable in amounts of 100K over 5 years. Assume adequately stated interest.
• AB = 400K (100K cash + 300K mortgage).
• AR = 800K (500K notes + relief of 300K mortgage).
• Gross profit = 800K (AR) – 400K (AB) = 400K
• K price = 500K (face value of notes) + ($0) (extent to which mortgage exceeded basis)
• Reportable gain = 100K payment x 4/5 = 80K
• 80K over 5 years adds up to 400K, or X’s total gain on the transaction.
6) After-acquired mortgage = Assume that the mortgage above was an after-acquired mortgage, so X’s basis is only 100K. The result changes:
• AB = 100K cash
• AR = 800K (500K notes + 300K mortgage)
• Gross profit = 700K
• K price = 500K (face value of notes) + 200K (excess mortgage over basis) = 700K
• Reportable gain = 100%.
• Every payment is reportable in full b/c X used the mortgage to offset his basis upfront.
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